I’ve been investing for over 35 years and having lived through a number of speculative bubbles you start to get a feel for them. Today, I believe we have some pockets over very over-valued assets such as certain high growth tech and biotech stocks and SPACs. So, today I want to talk a bit about ‘The Winner’s Curse’ and relate that to IPOs and the big boom of SPACs we are in seeing now. Based on historical data which we’ll talk about, a good rule of thumb is to stay away from the frenzy for a few years. If the idea is solid, you can jump on after the excitement dies down and avoid a lot of pain.
What is ‘The Winners Curse” ?
The Winner’s Curse can be summarized as the likelihood that the winning bin in an auction is likely to exceed the true value of the item. The term “Winner’s Curse”, was coined by engineers who observed poor investment returns for drilling companies bidding for offshore oil rights in the Gulf of Mexico. The returns were studied in a research paper, ‘Competitive Bidding in High-Risk Situations’. Citation below.
One of the basic ideas in the paper is that the winning bidder for the oil tracts had imperfect and high expectations for the growth projections. The idea being that the most optimistic bidder’s will over-estimate the value of a project and as a result get lower returns then expected. Also, emotions have a lot to do with auction type situations. I have first hand experience with the given my experience with M&A at Intel Corporation. The basic problem is that once a company starts down the path of acquiring an investment it can have a tendency to become ‘competitively irrational’. Justifications for a higher price in the face of a competitive bidder may become a problem. Also, there is a desire to ‘win’, vs other bidder’s even if winning isn’t in your own best interest. There is an element of scarcity and multiple suiters all emotionally invested in ‘winning the price’. Experience tells me, look out for such conditions and be very, very careful in how you proceed!
Initial Public Offerings and Investment Return
IPOs are an interesting case study. Typically, we have a company with a hot new idea, who is looking to solve a new problem or disrupt an entrenched competitor with ‘a better mouse trap’. The ‘pitch’ may include some hotshot CEO and clever management team along very compelling storyline about how large the total available market is (TAM), how fast the TAM is growing and how quickly the new hot IPO company will grow by taking market share. Many investors (bidder) are willing to line up and buy shares. The number of shares are ‘scare’ and the investment bank who is underwriting the deal may be over-subscribed and may ‘allocate’ shares. This is starting sound a lot like the just the type of environment found in The Winner’s Curse. And don’t be fooled, the IPO company and the investment banker’s have much better information about you do regarding the company’s prospects. These parties are very very savvy and they are very experienced when it comes to know when to take the IPO to market.
What is the performance history of IPOs?
In a research paper published in 2008, “Which, Why, and for How Long Do IPOs Underperform?”, the authors studied over 7,000 US startups that went public between 1975 and 2005. They found that, indeed, the IPOs under-performed in their first year of their life. This includes adjusting the company’s returns for market beta, size, momentum and valuation (Carthart 4-factor model). After two years the IPO companies returns were no longer significant different from the other public companies.
Could it be that the frenzy to buy the IPO stocks and the first year of life are causing investors to overpay for the stock? The performance data supports that idea. If true, why not wait for the IPO company to establish itself in the first year before buying? On average you would have a better investment strategy. In that time period you will get a track record of earnings and financial results. If the growth forecasts and IPO pitch were too optimistic, you may get a sense of it as the added scrutiny of the public markets is shined on the new darling IPO.
What about the latest craze, SPACs?
SPACs are Special Purpose Acquisition Companies. This structure allows companies to bypass the normal rules of the IPO process including limiting what the company can say and not requiring the same financial disclosures. A promoter raises money to be able to acquire a private company. A share price of $10 is set. the SPAC shares trade publicly. Later, the two companies become one and almost magically the private company becomes public.
SPACs are great from the promoters and private companies that otherwise want to get to market quickly. In a booming stock market, timing is very important to maximize share price. The promoter collects a very large fee, similar to a hedge fund taking 20% of the returns. The company may be able to get a higher valuation from the promoter and founders may have less restrictions on selling there shares… Everyone wins, right? No.
Once again, doesn’t this sound a bit like a frenzy to get on the latest ‘hot’ IPO deal? Only in this case now the deal as promoted as ensuring ‘the little guy’ retail investor can get in on a new stock issue where they may not be able to do that with an IPO on allocation. So, here again we have a frenzy situation, a scare investment and many bidders. A very similar setup to the oil fields in The Winner’s Curse.
Once again, we can look to real research to see how SPACs have performed. Once again, the results are disappointing. In a working paper titled, ‘A Sober Look SPACs’, the authors abstract includes the following:
“We find that costs built into the SPAC structure are subtle, opaque, and far higher than
has been previously recognized. Although SPACs raise $10 per share from investors in
their IPOs, by the time the median SPAC merges with a target, it holds just $6.67 in cash
for each outstanding share. We find, first, that for a large majority of SPACs, postmerger
share prices fall, and second, that these price drops are highly correlated with the
extent of dilution, or cash shortfall, in a SPAC. This implies that SPAC investors are
bearing the cost of the dilution built into the SPAC structure, and in effect subsidizing the
companies they bring public.”
Conclusion
Given the low interest rates and huge amount of monetary stimulus coupled with a positive economic recovery, excesses are starting to appear. Many questions are coming in about getting on whatever the fastest growth assets are – high growth tech and bio tech, IPOs, cryptocurrencies and SPACs.
In times like these, it pays to be prudent and value assets you are buying based on their intrinsic value, not based on how much return the thing generated last year or overly optimistic growth prospects. We humans have a real fear of missing out (FOMO) and that clouds judgement. Just like a company will over-pay for an acquisition, so to do investors over-pay for IPOs and SPACs and whatever else the craze of the day is.
Be patient. Look for proof of returns and growth. Especially when the valuations are as high as they are today. The last SPAC I looked at had under $250M in revenue and the valuation was set at $8B. There were no profits. You may believe in the company with your entire heart. OK, then why not way 12-24 months and see if the company executes. The data shows that you aren’t missing anything. In fact, you would be better off just investing the money in the market for a year and then invest in the newco one year later.
Sources
E.C. Capen, R.V. Clapp, W.M. Campbell. Competitive Bidding in High-Risk Situations. Journal of Petroleum Technology, 1971. https://www.cs.princeton.edu/courses/archive/spr09/cos444/papers/capen_et_al71.pdf
Klausner, Michael D. and Ohlrogge, Michael and Ruan, Emily, A Sober Look at SPACs (October 28, 2020). Stanford Law and Economics Olin Working Paper No. 559, NYU Law and Economics Research Paper No. 20-48, Available at SSRN: https://ssrn.com/abstract=3720919 or http://dx.doi.org/10.2139/ssrn.3720919
Hoechle, Daniel and Schmid, Markus, Which, Why, and for How Long Do IPOs Underperform? (February 26, 2008). Available at SSRN: https://ssrn.com/abstract=1098368 or http://dx.doi.org/10.2139/ssrn.1098368