WASHINGTON, May 25, 2012 – By now, nearly everyone knows that Facebook’s (FB) endlessly-publicized, massively hyped IPO was a major bust. Our first clue occurred the very day FB opened, last Friday, May 18. You could tell from the trading action that the stock wanted to break its IPO offer price of $38 per share. Things went downhill quickly from there.
To experienced traders, it appeared that lead underwriter Morgan Stanley almost certainly needed to support the stock to keep it from breaking that IPO price before the close. That’s rarely a hopeful sign for a supposedly red hot new issue.
Monday’s trading action confirmed that nervous investors’ suspicions were on the money. FB dropped like a stone, roughly 11 per cent. Tuesday it was down approximately 10 per cent more with the price recovering slightly later in the week but resuming its downward trajectory today.
Eager small investors got hosed throughout the entire process, making this social networking bet arguably the most embarrassing IPO in recent memory. As details emerge, the story becomes even more disgusting, but frustrating, too. The screwing of small investors in hot IPOs has been routine for decades now. The problem with the Facebook IPO is that it jumped the shark. And the repercussions of this are only just beginning.
Fair warning: long article.
Why did the Facebook IPO bomb?
Famously eccentric investment advisor Joseph Granville used to preach, “Don’t be a bag holder.” Back in the 1980s, he was preaching to Wall Street’s designated bag holder, the small investor who, curiously, is today’s bag holder as well at least when he’s around. Small traders remain at a disadvantage when competing with the pros for numerous reasons. A major one being the lack of key information that’s frequently shared (illegally) to insiders.
The Facebook IPO was, as one anonymous 1930s wag put it, “One d–-d thing after another. Examples:
- This IPO was pushed in front of potential investors’ faces for at least a year, even as fat cats, hedgies, and foreign investors inhaled privately issued shares at a bargain basement price. You can bet these early insiders didn’t pony up $38 per share, FB’s eventual IPO offering price, now known to have been ridiculously inflated.
- Having spread the word, insiders sat on their stock, waiting for a compliant financial media to create the buzz that would help them unload their shares for a big markup in the upcoming IPO. The media complied, flogging the Facebook story mercilessly, ending with a final full week of nonstop hype rivaling the annual ad and hype overkill that marks the week prior to the Super Bowl. This actually led to IPO fatigue. People were getting bored with this, but it kept on coming.
- While beating the sales drum, the underwriters as well as the certifiable morons financial journalists who hyped the story also created a myth of scarcity. I.e., “you better buy this stock if you can, since it will go up dozens of points after you open, enabling you to retire immediately if you can get some.” This soon proved to be a sad and cynical joke. But the little guy wasn’t in on it.
- Reportedly urged on by greedy Facebook execs themselves, lead underwriter Morgan Stanley and others in the underwriting syndicate kept upping the whispered asking price of the new shares. The scandal: they had to be aware that the investment bankers’ own analysts had quietly lowered Facebook’s upcoming earning estimates even as the pre-IPO roadshow was underway. A roadshow, BTW, that FB CEO and hoodie-meister Mark Zuckerberg seemed barely interested in supporting.
- Meanwhile, said analysts let insiders and important wealthy clients know about these double-secret downwardly revised estimates while withholding that information from the retail investor. At the same time they upped the offer price to the aforementioned $38 per share, adding into the offer pot 25 per cent more shares than were originally anticipated due to additional greedy insiders wanting to cash in on the offer. We are told there is a firewall between a given firm’s analysts and the people responsible for managing an IPO. But frankly, anyone who’s worked in an office of any decent-sized company knows that a hot secret won’t last for long no matter what the alleged constraints on “need to know” information. Everyone was in on the joke except us.
- FB’s ever-increasing offer price whisper number, coupled with the dilutive effect of the huge additional amount of shares added to the offering, had the effect of letting all the air out of the IPO. Shares were actually in serious oversupply and there was plenty of stock available for the little guy who never had a clue as to what was happening behind the curtain. Late Thursday, the compliant media were fed stories that, although the IPO offer price was rumored to be at the high end of a $35-38 range, technicalities could cause the stock to go public at an offer price as high as $45. This was pure baloney, but the media bit, convincing more and more public investors that at even $38 per share, Facebook would be the bargain of the century.
Traditionally, most underwritten IPOs try to factor in at least a small pop to keep their best customers interested while potentially attracting new ones. This is done at least in part by limiting the number of shares available in a given offering.
But in this case, the collective greed of Facebook, and/or Morgan Stanley et. al., and/or the rest of the underwriters—not to mention insiders with lots of stock to dump at a huge profit—broke the unwritten rule. By the time FB opened, there was no pop left to be had by the public. But of course, everybody knew this except the public.
The coup de grace was the inept way the NASDAQ handled the opening of the IPO on its own exchange. It was the final chapter of an epic fail whose last chapter remains to be written. The details of this are so “inside baseball” as to not be worth recounting here. Suffice it to say that the NASDAQ was unprepared for the scope of this offer, and it added considerably to the problem of opening the stock last Friday.
Adding insult to injury
By the end of the day, the bulk of discouraged investors had either broken even, gotten out on the stock’s fleeting pop to $42, or chose to bail later rather than lose money outright. The little guys? Many still had no clue as to whether or not their orders or cancels had even been executed. Some of them apparently still don’t, even as of today.
More on that double-secret downward earnings revision
Those who remained in the stock over the weekend had their hearts broken Monday and again Tuesday as the stock continued to waterfall back to earth and perhaps into the bowels of Hades.
Yet the real scandal of this debacle only came to light around noon Tuesday of this week when a Reuters reporter revealed a stunning piece of news which has since been confirmed: Even as Facebook and its underwriters were traveling the country with their pre-opening sales “roadshow”—long an IPO tradition—Morgan Stanley’s underwriters had worked Facebook’s numbers again and discovered company numbers didn’t look as good as everyone had thought. (Other sources state that Facebook itself informed Morgan Stanley of the discrepancy.)
According to a later Reuters report cited by Business Insider, “the underwriter analysts cut their estimates after Facebook issued an amended IPO prospectus in which the company mentioned, vaguely, that recent trends in which [Facebook] users were growing faster than revenue had continued into the second quarter.” Few retail investors would have been able to divine what was happening from this deliberately obscure language.
Worse, Morgan Stanley analysts apparently had selectively informed their biggest and best clients about the downgrade. At no time did the little guy ever learn about this internal downgrade—knowledge that, clearly would have justified a downward revision in the final pricing decision. One wonders if even those involved in the roadshow knew about this internal downgrade. Either way, the implications are ominous.
Worse still, Reuters reported that “JPMorgan Chase and Goldman Sachs, which were also underwriters on the deal, each revised their estimates during Facebook’s IPO road show as well, according to sources familiar with the situation.” So much for transparency. On CNBC, analyst Henry Blodgett said he’d never heard of an investment firm’s analyst downgrading an IPO stock during its pre-sale roadshow, stating flatly that “it’s simply not done.”
As they used to say back in the days of the Watergate scandal, “What did you know, and when did you know it?” It will be interesting to see if we’ll get an answer to that question from Facebook’s underwriters in the coming weeks. Congressional inquiries are already being launched.
The investment deck ended up being double-stacked against investors who weren’t in the know, because investors and firms who were in on the inside information either pulled their orders or severely reduced them, leaving even more slack in the eventual float. This increased supply simply provided more room for the stock to fall even further.
But wait! There’s more!
We are receiving reports today that only make matters worse when it comes to screwing the small investor. Again, we have to oversimplify here, but stay with us.
If you want to place a downward bet on a stock—perfectly legitimate—you short it. That is, you borrow stock you don’t own, sell it, watch it go down (if your strategy is working), then buy it back and return it to the owner, pocketing a profit from the spread on the way down. To the average retail investor, this seems perverse, but it’s totally legit and is actually beneficial to certain markets to maintain orderly trading.
But the catch is, you have to have available stock to borrow. This is no problem for stocks with a huge float like IBM. But in the case of the Facebook IPO, since the stock was newly issued, there was no stock available to short, at least until this past Tuesday when stock bought on Friday “settled” and was legitimately owned by its new buyers.
Well, sort of.
Actually, as we’ve mentioned before, IPO stock is actually bought in its entirety by the underwriting syndicate. Then it’s this stock that’s sold to institutions and the public on the day of the offer. Now here’s the trick: since the underwriters already technically owned all of Facebook’s stock (save that of selling shareholders), their holdings were already “settled.” Hence, from day one, they could, from withheld inventory, offer their best clients plenty of stock to borrow and short. Retail buyers were more or less closed out from this possibility, another unfair advantage.
Word is out today that Goldman Sachs (them again) and J.P. Morgan (them again) were happily lending out shares to short from the opening of the gate last Friday. Since their insiders already knew that the stock was a turkey, the shorting started in earnest the very day of the IPO. As new purchasers of the stock “settled” on Tuesday, more and more stock became available for shorts. As of this morning, it’s estimated that fully 8 percent of the “float” (stock available to trade) of FB is short, and that number is probably increasing today.
To Morgan Stanley’s credit, they made no shares available for shorting, apparently due to corporate policy. The idea, we’d assume, is that an issue’s lead underwriter would deem it unseemly to help others bet against their own IPO even as it was in the process of going public. Clearly, however, Morgan Stanley’s major underwriting partners had no such compunctions.
Heavy shorting tends to pile-drive a stock down and keep it there. This was a main reason behind the severe banging down of bank stocks in 2008 that led the SEC to ban short selling entirely in these issues until things settled down. This activity used to be constrained somewhat by the old “uptick rule.” But the SEC irresponsibly eliminated that rule just prior to the crash, which arguably exacerbated that disaster.
The same thing is now happening to Facebook.
An additional outlier occurred just a day before FB went public. GM grandly announced that they were pulling millions of dollars of advertising from Facebook, proclaiming that their Facebook ads were pulling in no business whatsoever. Talk about sowing fear and doubt. While GM has every right to place advertising wherever they want to, why the heck did they make this very public announcement right before the Facebook IPO was scheduled to price? It’s a good question. But as of today, GM continues to refuse to comment on the timing of this announcement.
Word is also in that high-frequency traders have also gotten in on the fun, happily throwing in quickly canceled bids that often obscured the true bid-ask spread of Facebook shares. When little guys bit on these prices, they were already obsolete and the HFTs quickly pocketed their arguably ill-gotten profits. (Sadly there’s nothing illegal about this. Yet.)
As details like this emerge, one can’t be faulted for thinking that the entire Facebook IPO pageant is failing to pass the smell test.
Morgan Stanley’s analyst(s), as well as those of Goldman Sachs and J.P. Morgan (and perhaps others) effectively tipped off their large, important investors in advance that Facebook’s IPO might not be worth the offer price as earnings estimates upon which that price was at least partially based had been revised down significantly.
More outrageously, this insider action occurred during the ongoing IPO roadshow according to Reuters. In the face of this all, Morgan Stanley and Facebook ignored all the signals and seriously overpriced the offer. Maybe greed is good, but it never seems to help the little guy. (As we finish this article, the first class-action lawsuits have just been filed against both the underwriters of this issue and the NASDAQ.)
Just prior to the offer, GM sabotaged the IPO with an ill-timed negative announcement that seems, in retrospect, almost malicious.
Almost simultaneously with the commencement of public trading in the stock, Goldman and J.P. Morgan worsened the atmosphere by lending plenty of stock to short, thus betting against their own IPO and those who’d bought the shares.
As if on cue, NASDAQ screwed up the IPO opening by mishandling HFT and institutional order cancellations. This delayed both the IPO opening trade and subsequent order matches so significantly that fearful investors also began to cancel orders, causing open interest to drop off severely.
As of today, many retail clients are still complaining of orders badly executed, orders executed multiple times, and orders or cancellations that were never executed at all. It could take weeks to sort this out.
Both the NASDAQ and Morgan Stanley are apparently going to be on the hook for some of this nonsense. How much, no one can yet estimate. It looks like Facebook is getting hit with class action suits as well. Good. They deserve it for their collusion in what clearly looks like a case of contempt for the average investor.
The overarching issue here is that after a cynical campaign of hype, all parties involved in the Facebook IPO caused this new issue to bomb completely and totally, save for the prime directive of getting Facebook more capital than it probably deserved. The stock continues to flounder, harming retail investors who’d finally decided to try the market again with a sure thing. There’s a lesson there, but maybe this wasn’t the time for it, given the current confidence-sapping situation with Greece and the Euro.
The end result? Little guys are even less likely to buy stocks again then they were a few weeks ago. And this is what’s keeping the market from growing and expanding.
It’s now obvious to the public, as if it weren’t already obvious before, that Wall Street is rigged against those who don’t happen to be rich insiders. The insiders continue to access crucial information on a given stock that never reaches the public until it’s too late. We wonder why something that’s allegedly illegal continues to happen without any accompanying perp walks. No. Actually, we don’t. The politicians and the regulators are in the hip pockets of politicians and regulators. Move along, please. Nothing to see here.
It’s already clear to the public that, if you gamble in Las Vegas, you can occasionally win. That said, the public is increasingly convinced that if you try to invest on Wall Street, the dealers will NEVER permit you to win.
The SEC and the Federal government have been asleep at the switch on questionable activities like this for at least two decades, possibly more. One has to ask, what are we paying these people for anyway?
Hope and Change 2012. Don’t miss the next thrilling episode.
Disclosure: Readers of this column and Morning Market Maven will recall that the Prudent Man decided to roll the dice on Facebook last Friday, grabbing a small position in FB just a little over the $38 IPO price. Our intent was actually to experience the ride in whatever direction it took and report back on the experience. We actually suspected things might end badly, and they most certainly did but considerably worse than we expected. We’re now reporting back, rather more vehemently than we thought we would. This was one fishy deal from the get-go.
On Monday of this week, we paid the price for our momentary act of reality-show style imprudence, prompting us to exit our Facebook shares slightly north of $34 for an approximately 11 percent loss. With one brief respite, the stock continues to plummet as of this writing, currently trading in the vicinity of $31 per share more or less. Which makes us feel fully vindicated for bailing out of this stock at the earliest sensible opportunity.
Will we return to this stock anytime soon? Nope.
If you’ve read our report above, you’ll quickly see that key information was withheld from individual investors; that the opening of the IPO was likely gamed; and that the NASDAQ’s ability to successfully open a hot new IPO is seriously in question as is the ability of the SEC to successfully protect the public from this kind of crappé, if you’ll excuse our French. Add the cynical availability of shares to short from the outset, courtesy of Goldman and JPM—plus, the apparent unwillingness of Facebook’s sainted geniuses to say anything about this mess on the record—and you have a stock that’s been thoroughly soiled. Why bother to get near it?
As the saying goes, you don’t know what you don’t know. Obviously we sure didn’t. Whether Facebook, the company, eventually proves to be a viable business model is of little concern to us at this point. Until and unless the smoke clears from this historic trading disaster, we’d strongly advise that investors avoid getting anywhere near this latest disaster, already 2012’s ugliest dog of the NASDAQ.
Disclaimer: The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate.
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