Look Out for Dot-Bomb 2.0


The red-hot success of recent IPOs by Zillow (Z) and Linkedin (LNKD) has investors feeling lucky, investment bankers drooling, and entrepreneurs racing to take their companies public.

Little wonder that returns-starved investors are chasing growth by bidding up shares of new initial public offerings. Real estate is in the tank, savings accounts are yielding zilch, and the stock market has roller-coastered back to even over the last decade. But like every bubble before this one -- tulips, the Nifty Fifty, real estate, etc. -- this version of dot-bomb 2.0 will leave investors bruised and bankers laughing.

Here's how you can avoid getting burned, and cash in on the trends driving these stocks without taking on all the risk.

Why IPO Prices Go Crazy

The mania around social media, smartphones, and tablets, and the blurring of online and offline commerce is drawing investors like moths to a flame. Pouring gasoline on the fire is the soaring popularity of a wily method for companies going public: the low-float IPO.

Low-float IPOs work like this. Instead of the going-public company and its founders selling gobs of shares to new investors right from the get-go, they sell only a tiny sliver. That contrived scarcity creates a big imbalance between supply and demand, which sends the stock skyrocketing to absurd heights.

Real estate data website Zillow, for example, zoomed 79% on its first day of trading yesterday. The stock now sells for a ridiculous 27 times sales. Reality check: Hyper-growth innovator Apple (AAPL) sells for only 3.5 times sales.

Selling companies and their founders love low-float IPOs for several reasons:

  • The engineered boom in the stock price makes the company's early investors paper-rich overnight.

  • It creates tons of buzz and free PR for the business.

  • Most importantly, it allows the company and its early investors to slowly dump their shares over time at a higher price than if they'd sold them all from the outset.

Beware of Bankers Bearing Gifts

Here's where the laughing bankers come into play. They'll rake in more fees by helping companies slowly unload their shares over time via secondary offerings. In order to keep the music playing, they're using some old and new tricks of the trade to lure investors into gobbling up these IPOs at sky-high prices.

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The new tricks include low-float IPOs and focusing on user and member counts, which is this era's version of the dot-com era's focus on clicks and eyeballs. The old trick is using valuation smoke and mirrors. Bankers are shifting focus toward companies' sales growth and away from their mounting losses and questionable business models.

Tip: Price-to-sales ratios are the figures investment bankers use when they want to promote a stock that doesn't earn any money. If these companies were profitable, bankers would be emphasizing price-to-earnings ratios instead.

Use Stupid-High IPO Prices to Find Bargain Bin Deals

The bad news is that the low-float IPO craze won't end well. Small-fry investors who pile into shares of these wildly overvalued businesses will end up getting burned. Steer clear.

The good news is that, unlike the first dot-com bubble, this latest bubble is smaller in scope and its bursting won't send other stocks crashing in its wake. Even better, Mr. Market's mad rush toward splashy IPOs has left tech stalwarts selling at bargain bin prices. Ironically, some of these titans are the best positioned to profit from the social, mobile, and local booms that are driving up the stocks of their smaller, flash-in-the-pan rivals.

Google (GOOG), for example, isn't just firing on all cylinders with its core search business. Its mobile operating system, Android, has vaulted to industry leading market share, its Google Offers deals service is expanding to new markets, and its latest attempt at a Facebook killer, Google+, is off to a smashing start. Or take eBay (EBAY), whose PayPal platform is growing like gangbusters and has twice raised its estimate for mobile payment volumes in 2011. They both have proven business models, great leadership teams, and Fort Knox-style balance sheets.

But whether you take Google, eBay, or none of the above, the most important thing is you keep your wits about you while this latest IPO bubble inflates and bursts. As Warren Buffett is fond of saying, be fearful when others are greedy and greedy when others are fearful.

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Motley Fool senior analyst Joe Magyer owns shares of Google. You can follow his musings on Twitter and on Google+. The Motley Fool owns shares of Apple and Google. Motley Fool newsletter services have recommended buying shares of eBay, Google, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple.