IPOs: Investors are being conditioned like puppies
As someone who recently adopted a puppy, I've found myself going back over the basics of operant conditioning – luring a dog into some desired behavior with a juicy treat and rewarding it with said treat.
The idea is to fuse the desired behavior and the reward inside the dog's mind and at that very moment, give it some repeatable cue, like an enthusiastic “Yes!” or a clicker in your hand.
As I thought about this, it kept reminding me of something in the back of my mind, some similar dynamic I'd been seeing around me. It hit me on Friday what it was, when Nutanix went public and more than doubled on its first day of trading. There is a similar kind of operant conditioning process going on in the tech IPO market.
As you've been reading over and over, the IPO market has been in a deep slumber for most of 2016. That changed over the past couple of weeks as five tech companies debuted on US markets, each one seeing their stock rise 20 percent or more on the first day of trading, according to data from Renaissance Capital. That has nicely primed the pump for other tech startups that have been waiting to enter the pipeline.
Actually, the priming process began earlier than that. In May, Acacia Communications, an optical-networking company, went public and rose 26% on its first day. Acacia has since risen another 255 percent. In June, Twilio went public and saw its stock rise 92 percent on its first day. Like Acacia, Twilio was more of an enterprise play than the kind of brand-name company that draws in retail invetors. But it proved to be an important test of investors' appetite for tech offerings. Twilio has since risen another 139 percent since its notable first-day pop. Too often after an IPO, a stock will rise for a few weeks and then slump, so it's somewhat encouraging that Acacia and Twilio have continued to rally for several months.
This is the kind of behavior investment banks love to see in the public markets because it makes it easier for more IPOs to come on in. In the past two weeks, five more tech companies have gone public, all with those first-day pops. Among them, a pattern has emerged: enterprise companies float a small portion of shares, priced conservatively, into a stock market starved for new opportunities.
You can almost hear the conditioning process happening, rewarding tech IPO buyers with delicious first-day pops. Everbridge, a mass-messaging company, rises 27 percent. Click-click. The Trade Desk, a programmatic ad company, rises 67 percent. Click-click. Gridsum Holding, a Chinese digital-ad platform, rises 21 percent. Click-click. Tabula Rasa, an online-prescription services company, rises 24 percent. Click-click. On Friday, Nutanix, an IT infrastructure company, rises 131 percent. 131 percent! Click-click-click-click!
Nutanix is one of the larger tech IPOs of the year, second only to LINE, the Japanese messaging company that co-listed shares in Tokyo. Nutanix' cloud platform combines low-cost, scalable servers with virtualization and storage technology, an appealing market for tech investors. Revenue grew by 84 percent to $445 million in the year through July, but operating losses are still equal to 37 percent of revenue. Nutanix went public with a $2.2 billion market cap, equal to 5 times its revenue. It closed Friday with a $5 billion market cap, equal to 11 times revenue. It went from cheap to expensive in one trading day.
There is something about the stock market that can take a bunch of maverick investors and turn them into a pliant herd. For the past couple of years, many investors have been skeptical of tech IPOs, especially ones that have been posting steady losses. Now, they are coming around to be more receptive tpward them, especially the ones that have been posting steady losses. Most of these companies are losing money in 2016, and most of them have a long history of losing money. But all have growing revenues.
A year or so ago, investors were finicky about fast-growing, money-losing tech IPOs, but now they are lured by the kind of first-day pops that signal investor demand. The 12 tech companies to go public in 2016 had an average first-day rise of 42 percent, according to data from Renaissance. For all 2016 IPOs in all industries, the average first-day gain is 17 percent. The aftermarket performance is stronger in tech as well. Tech IPOs are returning an average of 89 percent from their offering prices, compared with a 45 percent gain in all industries.
To those who remember the IPO mania during the dot-com bubble, this may sound uncomfortably familiar. But the IPO bubble of 1999 was another market entirely, with dozens of companies with little hope for a future shoveled out into the market and performing like fireworks - a pleasant soaring followed by an explosion. This is closer to business as usual for investment banks, managing investors expectations in a way that hopefully raises them enough to send some bigger IPOs their way.
It's also unlikely to end in tears, at least not for some time. More tech candidates are wending their way through the IPO pipeline, including cloud-software maker Coupa Software as early as next week. Coupa fits the same pattern: small enterprise company, growing revenue, history of losses. Still others will follow until the window shuts around the election (depending on who wins) or the holiday season. All of this is setting the stage for the bigger show in 2017, when well-known names like Uber and Dropbox may try to go public.
There are a few potential problems. Institutional and most accredited investors know how the IPO markets work – including the ability of banks to engineer IPO outcomes – but retail investors who may try to buy into the first-day pops often don't. The longer a wave of IPOs lasts, the less conservative the pricing of the offerings becomes. Less promising, sicklier companies come out and try to ride the wave. And after enough lemons make it public, investors lose their appetite for IPOs that can't show they can make a profit.
There is also the risk that something – some crisis in European banks, some unexpected rise in US interest rates, some dunderhead being elected President – could cause the overall markets to swoon, derailing the delicate rally in tech IPOs before some of the big unicorns can make their way in. But these are things to worry about later on. For now, we're enjoying lots of sweet, sweet first-day pops. I mean, who miss out on tasty treats like that?