Snapchat parent Snap made its debut on the US stock market just over six months ago, in what was one of the most widely hyped initial public offerings (IPOs) in years. The initial euphoria didn't last long: Snap shares have more than halved in price since then.
Snap’s collapse is no great surprise. Anyone who invested in the stock was making a bad bet and ignoring a mountain of investment evidence.
The more demand there is for a stock, the more expensive it is. And there was demand for Snap stock – lots of it.
Last February we warned in these pages that Snap's proposed $20 billion-$25 billion valuation would mean a stratospheric price/sales ratio of 55, a multiple never achieved in any US IPO in recent decades. For comparison, Google traded on 10 times sales at the time of its 2004 IPO, while many investors were stunned by Facebook's price/sales ratio of 25 following its 2012 IPO.
If a company is priced for perfection, then it must deliver perfect results. One study, The Role of Expectations in Value and Glamour Stock Returns, found that high-priced glamour stocks routinely fall in price when they miss earnings estimates. (In contrast, cheap value stocks tend to rise in price even when they miss estimates and when business fundamentals deteriorate, highlighting the importance of expectations when it comes to investing).
Unsurprisingly, then, Snap shares were crucified after falling short of analyst estimates in May and again in August.
Separate research confirms investors shouldn’t let a good story blind them to valuation. The cheapest technology stocks have historically returned 14.5 per cent annually, according to money manager Patrick O’Shaughnessy, compared to just 3.5 per cent for the priciest tech stocks.
Furthermore, almost a third of the worst performers in any given year tend to have begun the year trading at very lofty levels, he found.
Beware expensive, cash-starved stocks
Snap enthusiasts pointed out that Facebook was also lambasted as overpriced when it floated in 2012, but it turned out to be a fantastic investment. Google, too, was seen as pricey in 2004.
There’s one crucial difference – both were very profitable, with Facebook churning out profits of more than $1 billion in 2012. In contrast, Snap “incurred operating losses in the past, expects to incur operating losses in the future, and may never achieve or maintain profitability”, as the company admitted in its prospectus.
Buying into high-priced stocks in need of cash is a dangerous proposition, according to a recent Stanford study, Sexy or Safe: Why Do Predicted Stock Issuers (PSIs) Earn Low Returns? It found the most likely companies to issue stock are loss-making firms with high valuations and "positive price momentum" – that is, "sexy" glamour stocks that want cash from eager investors.
Such stocks are meant to be high-risk, high-return vehicles but they rarely deliver the goods. Over a 36-year period, high predicted stock issuers generated the same returns as US treasury bonds, and were nine times more likely to delist for performance reasons. In contrast, low predicted stock issuers – cheap, profitable firms with no pressing cash needs – outperformed their high-issuing cousins by roughly 10 percentage points per year over the same period.
In other words, expensive companies are bad enough, but when they’re losing money and looking for cash – run.
Prize probability over possibility
The aforementioned Stanford study begs the question: why are investors so keen to buy into overvalued and high-risk stocks with iffy fundamentals, when they could instead make a lot more money by investing in safe, profitable companies?
The authors found that, while the vast majority underperform, a select few do deliver huge, “lottery-like” returns. In other words, investors buy stocks they should avoid in the hope their ticket will be the winning one. They prize possibility over probability.
The same point is made by O’Shaughnessy. If you’re lucky enough to pick the right glamour stock, you’ll make a bundle. In a typical year, the best performing decile of glamour stocks will outperform the market by 115 per cent.
More often than not, however, you’ll regret purchasing such stocks. The median glamour stock has underperformed the market by 11 per cent annually, according to O’Shaughnessy, while the worst performers get slaughtered.
Of course, cheap stocks often get cheaper and sometimes go to the wall. On average, however, unfashionable value stocks significantly outperform the market.
“Over and over again”, says O’Shaughnessy, growth investors get seduced by the possibility of making a packet and ignore the probability their stock will disappoint. “Probabilities are boring, possibilities are exciting,” he says, but the savvy investor prizes probability over possibility, not the other way around.
Countless studies confirm IPOs tend to disappoint, with returns typically lagging the overall market. Although new companies like Snap generate the most excitement and hype, investors would do well to remember a simple rule – typically, the older a company is, the better.
The 2015 Global Investment Returns Yearbook noted that, over the previous 35 years, you’d have made more than three times as much money if you’d invested in a portfolio of companies that were at least 20 years old compared to a basket of stocks aged three years or less.
A similar point is made in a McKinsey report, Grow Fast or Die Slow, which examined the performance of 3,197 technology start-ups that went public between 1980 and 2013. Fewer than a third reached $100 million in annual revenues; 3 per cent hit the $1 billion level; and just 19 – far less than 1 per cent – ever topped the $4 billion level.
Don’t rely on analysts
In an ideal world, analysts would warn investors off glamour stocks. In the real world, they’re just as likely to buy into the hype. The Stanford study found analyst earnings estimates regarding high predicted stock issuers tended to be too optimistic.
This is confirmed by another study, Analyzing the Analysts: When Do Recommendations Add Value?, which found analysts generally recommend glamour stocks. Why? High-profile growth stocks "make for more attractive investment banking clients", with the study noting that analysts had "significant economic incentives to publicly endorse high-growth stocks with glamour characteristics".
In fairness, many analysts have been cautious about Snap from the start. It was initially one of the worst-rated stocks on Wall Street, with five of the first seven analysts to cover the stock issuing “sell” ratings (the other two gave it “hold” ratings).
Within a few weeks of the flotation, however, banks involved in the IPO were given the go-ahead to issue ratings. On March 27th, eight banks involved in the deal issued – surprise, surprise – positive ratings. Shortly after, the lead underwriter, Morgan Stanley, had to correct a report, saying a maths error meant it had overstated forecast earnings by billions of dollars. Nevertheless, its optimistic price target of $28 remained unchanged, the bank said.
Just a couple of months later, in July, Morgan Stanley surprised investors by downgrading the stock, saying it was “wrong” to be so bullish. That came too late for many. By then, Snap shares had almost halved in price.