Wednesday, 22 May 2013

Facebook: winners curse or irrational exuberance

It is a year since Facebook launched shares on the Nasdaq. They were launched at $38 per share and now stand at a lowly $26. Anyone who bought a share would have lost 30% of their money.
   At first sight this looks like a classic example of the winners curse. The winers curse captures the idea that the winner of an auction often loses money. IPOs (initial public offerings) are a textbook example of this. Here's the basic logic: If you ask 1000 investors to put a value on Facebook then the average valuation will probably be about right. But, shares are not sold to average investors. They are sold to the investors willing to pay the most. So, what really matters are the valuations of the most optimstic investors. And while the average investor will get the value about right, the most optimistic investors will not. They will overvalue the company and consequently pay too much. This is the winners curse: the investors who 'win the auction' to get Facebook shares would have been better to not bother.
    This is the textbook story, and it seems to fit the Facebook case pretty well. But, here are some things to add in to the mix. 
    One thing to consider is that the price of Facebook did increase in the first few minutes of trading up to $42, with a huge volume of orders. If you got a share at $38 and sold at $42 then that looks like good business. The stupid thing was to buy at $42! Its not clear whether buying the share after launch should be counted as the winners curse or a more general bubble effect that could be classified as irrational exuberance. I would call it the winners curse but others might not.
     Another thing to regonize is that many IPOs run without any winners curse. For example, the chart below compares the performance of Facebook with Google, Linkedin and Manchester United. We can see that investors who bought shares in Google or Linkedin would have done very well. Similar things were expected of Facebook. This still means its relevant to talk of the winners curse - investors in Facebook lost money - but it does suggest that the winners curse is less prevelant in IPOs than some might have us believe.
     A final thing to consider is the possibility of a 'winners bonus'. This is why I've put up the shares of Manchester United. The owners of United had originally planned to sell the shares for $16 to $20. They ultimately had to go for an underwhelming $14 (note that Google and Linkedin were launched at the top of their predicted range). Six months later the shares were up above $18. So, this is seemingly an example where easy money was there for the taking by buying the shares at a very low initial price. Clearly, the more that investors are caught by the winners curse the more cautious we might expect them to be in the future. With Manchester United they were seemingly very cautious. We essentially have the opposite of a winners curse.
    I think there's an interesting lesson in all this with regard to the efficient market hypothesis. According to this hypothesis the share price of a company always reflects the underlying value of the company. In that case an IPO is akin to any other auction because you are buying a good that has value in itself - a share is analogous to a painting, car, house or anything else you can get at auction. In reality, most think that the efficient market hypothesis is pretty dodgy. The share price of a company is more likely to reflect the game going on in the market rather than the fundamental value of the company. The price at any one time may, therefore, be well above or below fundamental value. That makes an IPO different to standard auctions because you are buying a ticket to a game and not something of value in itself. And so, while the winners curse is still relevant, its effects are likely to be overwhelmed by the game playing going on.

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