Last year in MoneyMorning, I wrote about “How unicorns” are the next “Tulip Bubble crisis.”
“Unicorns” are the name given by Silicon Valley to private start-up tech companies that have valuations of $1 billion or more. They're usually categorised as innovative, high growth companies.
But as I explained last year, many institutional investors pile cash into “unicorn” companies which drives up their valuations.
The problem is, when these investors pile too much cash in, valuations reach unsustainable levels. And one little piece of negative news will see the company's shares crash.
More importantly, retail investors who bought into it will make big losses.
That's exactly what's happened to one of the most anticipated IPOs in 2017.
Let me explain…
The biggest problem with hyped-up IPOs
You can imagine the hype and excitement that surround this listing from all kinds of investors – especially ordinary investors who wanted to buy the next big thing.
But there’s one massive problem and it’s one of the main reasons why you must avoid hyped-up IPOs
You see, Wall Street underwriters make millions from IPOs like Snap by hyping them up to the public, even when they know it won't be a good investment.
Since they're the sole distributors of the new shares to investors, they can make exorbitant underwriting fees.
In fact, the two lead underwriters Morgan Stanley and Goldman on the Snap IPO made a combined $46.8 million.
What’s more, underwriters and institutional investors on Wall Street were able to purchase Snap shares at the IPO price of $17.
But ordinary retail investors had to wait until SNAP stock debuted at $24 to buy in. So while these exclusive investors gained over 40% from day one, ordinary investors made nothing.
But here’s where it gets worse…
Two months after its IPO, SNAP stock fell down 23% in one day causing massive losses to retail investors. However, institutional investors/underwriters are still around 3% up from the price they bought it at.
Why Snap crashed 23% in a single day
Snap (owns Snapchat) lost a staggering $2.21 billion last quarter - a loss of $2.31 per share. That widely missed FactSet's estimated loss of $0.21 per share.
Much of the losses were to the Snaps IPO. The company was forced to pay billions to employees whose stock options vested when the firm went public.
This accounted for $2 billion.
What’s more, the company missed its daily active users (DAUs) target - the most important metric for social media companies.
Snap reported that Snapchat saw 166 million global DAUs, below analyst expectations of 167.3 million.
But even if you exclude the one-time IPO-related loss, Snap still lost $188.2 million in its first quarter. That was worse than market analyst’s projection of a $180.7 million loss.
This is another problem. Underwriters and institutional investors could have known about Snap’s financials but still hyped up the company’s IPO to boost the valuation and make a lot of money – which they did.
However, ordinary investors had no inside information surrounding Snap’s financials. So they could not have known the company was losing money.
Basically, ordinary investors were led into the lion’s den and have now lost a lot of money.
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So what should you do when a new company lists on the stock market?
If you really think a stock is worth your money, you should always wait for the company to release a few quarterly/half year reports.
That way you can prove it's worth your money.
You see, investing in IPOs always leans in the insider’s favor, which is why you should never invest in brand-new stocks that are driven by IPO hype rather than profitability.
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