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This course is an introduction to the stock market and stock investing for novices and experienced investors alike. Professor DeGennaro uses simple analogies to explain the origin of stocks and other securities, as well as their relative risks. He stresses the danger of trying to beat the market by trying to pick winners, predict price trends, or otherwise find opportunities that other investors have missed. Far better, he counsels, to own a well-diversified portfolio of individual stocks or stock funds, which tend to grow as the economy grows. He offers detailed guidance on how to pursue this course. Among the topics covered in these 18 lectures are how to open a brokerage account and choose a financial advisor; the essentials of mutual funds, including index funds, and exchange traded funds (ETFs); how to trade individual stocks, including how to use options; the relative advantages of traditional IRAs, Roth IRAs, and 401(k) plans; how to minimize transaction costs and use tax laws for your benefit; the dangers of frequent trading; and the basics of corporate balance sheets, income statements, and cash flow statements. For anyone who owns stocks or is thinking of entering the market, this course provides indispensable advice. If you entrust the management of your assets to a financial advisor, this course will give you the background you need to communicate more knowledgeably with him or her and be an informed participant in your own financial well-being.
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LearningTranscript
00:13Most of the time, as I've explained earlier in this course, we treat the market price
00:17of stock as being fair.
00:20It's not the right price, but it's the fair price.
00:23It's as likely to be too high as it is to be too low.
00:28With an initial public offering, or IPO, though, all bets are off.
00:34When 3Com's Palm division had its IPO on March 2, 2000, it went from its offering price
00:42of $38 to over $95 on the first day.
00:47If you're scoring at home, that's a 250% return in one day.
00:52By comparison, the S&P 500 barely budged, inching up less than two-tenths of one percent.
01:00Palm outperformed the S&P 500 by not quite 1,400 times that day.
01:08What in the world is going on?
01:10How do IPOs work, anyway?
01:13Is that price behavior typical for IPOs?
01:16That's a fabulous one-day return, but what's the long-run performance like?
01:23It turns out that the pricing of IPOs and their expected returns and risks are nothing like
01:30those of securities that are already trading.
01:33If you understand how and why companies go public, then you can better assess the benefits
01:38of investing in IPOs and those risks.
01:43Let's start by decoding what the name, Initial Public Offering, means.
01:48What is an IPO, anyway?
01:51Like so much of financial terminology, we benefit because the language evolved from what people
01:57use on Wall Street and financial markets.
01:59We can figure this out without turning to the Internet.
02:03Initial means first.
02:05Public means that whatever is going on isn't restricted to some select group of people.
02:11Offering sounds as if the company is selling something.
02:14A good guess of what an Initial Public Offering is would be the first time that a company sells
02:20something to the masses.
02:23If we deduce that, then the only thing we'd be missing is what the company is selling.
02:29It might be a new product, but in a course titled How the Stock Market Works, they're probably
02:34selling shares in the company's stock to the general public for the first time.
02:40And it's so often the case with finance.
02:43A little common sense gets us the right answer.
02:46An IPO is the first sale of stock by a privately held company to the public.
02:52Usually the company will be a smaller firm, often relatively new, and looking to grow more
02:58rapidly than it could without tapping a new source of funds.
03:02Why do companies go public?
03:05Let's see if we can come up with some reasonable guesses.
03:08First, who's selling the shares?
03:11The simple answer is the company.
03:14But if we remember that a corporation is just a legal shell that we wrap around a bag of goodies,
03:20then we realize that what we really mean is that the current owners are selling the shares.
03:27Put yourself in the place of a guy who started a company and built it over time.
03:31You may have sold a part of it to a partner, but you still own a big chunk of it.
03:36You might be worth $100 million, but $90 million is tied up in the company.
03:42That's not the recipe for a good night's sleep.
03:45You're not diversified, and a corporate disaster can wreck all of your hard work and financial success.
03:53Not all companies that have IPOs are still controlled by the founder, of course,
03:57but it's almost always the case that whoever does own the company at the time
04:02has a huge stake that didn't used to be so huge.
04:07That's one reason companies go public.
04:09The owner wants to cash out, either to diversify his holdings
04:13or perhaps to raise some cash to change his lifestyle.
04:17We said owner, but the odds are that there are several owners.
04:21When you brought your brother Tony on board as a partner, he bought 10% of the company.
04:27Now he wants to cash out and take early retirement,
04:30but he just can't do that because he can't find a buyer for his 10% stake.
04:35Your money is all tied up in the firm, too, so you can't buy him out.
04:39He's not happy about that, and that means you have an unhappy employee
04:43and an unhappy business partner.
04:46That's bad.
04:48You wouldn't have this problem if the firm were publicly traded.
04:53Shareholders gain liquidity by going public.
04:57Another reason firms go public is to make it easy to offer many employees a stake in the company's future.
05:04Sure, you could hire a team of lawyers to handle the documents
05:08to sell a small part of your holdings to your employees every time you needed to do that,
05:14but that just doesn't make sense.
05:16It'd be too expensive and time-consuming.
05:18Going public solves that problem.
05:21When a company grows to more than 500 shareholders,
05:25then it has to start filing a lot of documents with the SEC.
05:30Sometimes private companies decide that once they have to incur the cost of doing that,
05:35then they might as well take the plunge and go public.
05:38For example, Google went public about the time that it had to begin filing SEC documents in 2004.
05:47Keep your company founder's hat on for another minute.
05:51Suppose that business is good,
05:53and you could probably double earnings over the next couple of years
05:56if you could open a branch office and manufacturing facility in another part of the country.
06:02But that sort of expansion isn't cheap.
06:05Where are you going to come up with, say, $300 million?
06:09This is probably the main reason for having an IPO,
06:13to raise funds and have better access to capital markets going forward.
06:18You'll also attract the attention of analysts
06:20and pick up some credibility with customers, suppliers, and employees.
06:26Going public has drawbacks, though.
06:29IPOs require lots of legal work, and that's not cheap.
06:34The total direct costs associated with taking a firm public
06:38are about 7 to 10 percent of the amount of money raised,
06:42and that doesn't include indirect costs like management time
06:46that gets diverted from other corporate needs.
06:49I mentioned that IPOs require lots of legal work,
06:52so how does a company set about going public anyway?
06:55In principle, it doesn't sound too hard, does it?
06:58Just create the shares on a computer and sell them.
07:02How hard can that be?
07:05It turns out that simply issuing shares and selling them
07:09leaves out two important things.
07:12First, there's the legal system.
07:14The government won't let you issue shares and sell them
07:17without jumping through the appropriate legal and regulatory hoops.
07:21Maybe those hoops are a good idea, and maybe they're not,
07:24but they exist, and you have to jump through them,
07:27or you're not going public.
07:30Second, what's the share price going to be?
07:32Remember Lesson 12 when we tried to get a handle
07:35on corporate and share valuation?
07:38We learned that it was really hard.
07:41It's next to impossible for a private company.
07:43For a public company, we have lots of data
07:47and a reference point, the price history of the shares.
07:50We can't do that with a private company.
07:53The stakes are higher, too.
07:55If you sell 2,500 shares from your personal portfolio
07:59and settle on a price that's $2 too low,
08:02then you'll have left $5,000 on the table.
08:04An IPO might have 25 million shares.
08:08A mistake of $2 per share would cost you $50 million.
08:14We need help.
08:16We need somebody who has done this before.
08:19In fact, we need somebody who does this sort of thing a lot.
08:23We need an investment bank.
08:26That's a financial institution that serves as an intermediary
08:30between the securities issuer and the investing public.
08:33They decide the best offering price.
08:36Investment banks also help with mergers
08:39and corporate reorganizations.
08:42Investment banks even provide advice
08:45before they start the issuing process.
08:47They might help us determine the size of the issue
08:50or perhaps suggest that we delay the offering
08:53until market conditions or the company's prospects improve.
08:57Investment banks engage in a process called underwriting.
09:01Members of underwriting syndicates
09:03usually take the responsibility
09:05for selling the shares the company allocates to them
09:08at a specific price.
09:10The origins of the word underwriter
09:13seem to trace to a practice of having each risk taker
09:16write his name under the total dollar amount of risk
09:19that he or she was willing to accept.
09:22Today, it usually has a more general meaning,
09:25referring to the process by which investment bankers
09:28raise funds from investors on behalf of corporations.
09:33Want to know another reason for a company to use an investment banker
09:36when it goes public besides expertise and familiarity with the process?
09:41It's because IPOs are plagued with what financial economists call
09:45information problems.
09:48Remember when we discussed information problems in Lecture 3?
09:51In the case of an IPO, management knows a lot more than anyone else about the company's prospects
09:59and they've decided to sell now.
10:01Not last month, not next month.
10:04Why now?
10:07Management holds all the cards.
10:09They decide when to go public,
10:11they decide what news to release,
10:13and the incentive to overhype is powerful.
10:17Founders of companies talking about their companies
10:20are like grandmothers talking about their grandkids.
10:23They're excited, enthusiastic, and optimistic.
10:27And that's just fine.
10:28They should be excited, enthusiastic, and optimistic about their companies.
10:33But most people don't want a sales pitch from that kind of guy.
10:36They want straight talk from someone who has done this before
10:40with a reputation for doing it right.
10:44They want someone who has a lot to lose if he messes up this deal.
10:49Investment banks fit the bill.
10:52Potential investors can check their track record.
10:55Those investment bankers need investors to say nice things about them
10:59after the deal to potential future clients.
11:02They can't afford to ruin their reputation.
11:06I've been saying investment bank as if IPOs involve only one such firm.
11:11That's fine for smaller issues, but for larger issues,
11:15the firm assembles an underwriting syndicate.
11:18An underwriting syndicate is a collection of investment banks
11:21that pool resources to sell new securities to investors.
11:25The lead underwriter might be some firm like Golden and Sachs,
11:30and other participants might be Citigroup, Bank of America, Merrill Lynch,
11:34or smaller firms like SunTrust, Robertson, Humphrey, or Raymond James.
11:39The underwriting syndicate's job is to get the securities into the hands of investors
11:45and to get the proceeds from the sale into the issuing company's coffers.
11:50The lead underwriter does the heavy lifting.
11:53It'll analyze the company's financial statements in light of current market conditions,
11:58project its future earnings, and, with the help of potential investors,
12:03determine the number of shares to be sold and the offering price.
12:08That's a tough job, and the skills needed to do it don't come cheaply.
12:13The total sales charge for the shares is around 7% or 8% for IPOs.
12:19Sometimes just a couple of successful IPOs or stock offerings a year
12:23can be enough to meet an investment banking firm's earnings targets.
12:28It's not just tough, highly skilled work.
12:32It's boom and bust work, too.
12:35If you enjoy working 8 to 5 and then clocking out to enjoy life,
12:39then a career in investment banking is not for you.
12:43During the boom near the end of the 1990s,
12:46investment bankers were working incredibly long hours
12:49and making huge sums of money.
12:52But when the market collapsed in 2007 and 2008,
12:56even the best investment banking firms struggled mightily.
13:01Many failed, including the venerable Lehman Brothers,
13:04with roots tracing back to the 1850s.
13:07Job losses in the investment banking community soared
13:11as the underwriting industry came to a standstill.
13:15A lot of the syndicate's work isn't financial at all.
13:18It's legal.
13:19Somebody needs to complete and file dozens of complex documents.
13:25For example, a company will probably file several iterations of the registration statement,
13:31known on the street as the red herring.
13:33The red herring is a preliminary registration statement filed with the SEC.
13:39It gets its name from a passage in red stating that the company is not attempting to sell its shares
13:45yet.
13:46Think of a red herring as a rough draft of what will finally happen.
13:49It describes the new issue of stock and takes a guess at how the issuing company will do in the
13:55future.
13:56When I say, takes a guess, I'm not being critical.
14:00At this point of the process, nobody knows the value of the securities.
14:04After all, they do call it a red herring.
14:07Any number that's in the red herring would just be a guess.
14:11I'd know it's a guess.
14:12You'd know it's a guess.
14:13So does everyone else.
14:14Most of the time, a red herring doesn't even have the price or number of shares to be sold.
14:19The red herring will be revised several times as the underwriting process proceeds.
14:26If you found an old coin in your backyard, how would you set about determining its value?
14:32You'd probably show it to people who know about such things, including a few potential buyers.
14:37That's what investment bankers do with an IPO.
14:40They call it the road show.
14:42They travel around the country delivering presentations designed to drum up interest
14:47and to answer questions from potential investors.
14:50They're gathering information, too.
14:53By listening to the potential investors, the investment bankers begin to get a feel
14:58for what the offering price should be.
15:01You might think that investors would try to mislead the investment bankers
15:06by pretending to have little or no interest in the offering.
15:09If they can convince the investment bankers that the securities aren't worth very much,
15:14then they might be able to persuade them to set an offering price that's too low.
15:19The problem with that tactic is that when the securities are offered for sale later,
15:25the investment bankers will allocate them partly according to the amount of interest
15:29the investors displayed during the road show.
15:32Even if the investors have managed to fool the investment bankers into setting a low price,
15:38they won't get many shares at that low price because they didn't show much interest.
15:43That means they won't make much money.
15:45Telling the truth pays.
15:47There's a lot of give and take involved, too.
15:50Because investment bankers expect to have lots of other deals in the future,
15:54their reputation matters,
15:56so they have incentives to treat the security buyers well.
16:01Eventually, the investment bankers will decide that they have enough information
16:05to set a range for the offering price
16:07and settle on the number of shares to be offered.
16:10They'll incorporate this information into the red herring,
16:14make a few other changes,
16:15and eventually call the resulting document the prospectus.
16:19The prospectus is an official legal document.
16:23The Securities and Exchange Commission requires that the prospectus contain the information that you need
16:28to make an informed decision about the stock offering.
16:32That's part of the reason that a prospectus is also called an offer document.
16:39Before the underwriting syndicate takes the shares to the public,
16:42it'll sometimes have a pre-IPO placement.
16:46That means that some of the shares get sold to private investors just before the IPO takes place.
16:52Typically, these private investors are big players in the equity markets.
16:57They usually get a discount from the offering price because they're buying in quantity.
17:02Some people think that's not fair to small investors.
17:05The big players counter that it's a lot easier and cheaper for the underwriting syndicate
17:10to sell a million shares to one private investment firm
17:13than it is to sell a thousand shares to a thousand different investors.
17:19Investors who buy shares in the pre-IPO placement also agree to lock-up agreements.
17:25The underwriting syndicate doesn't want the participants in the pre-IPO placement
17:30to turn a quick profit by reselling their shares at the offering price
17:34immediately after the IPO itself.
17:37A lock-up agreement is a legally binding contract between the underwriters
17:42and the purchasers in the pre-IPO placement.
17:45A lock-up period can last for as little as 120 days or as long as a year.
17:51Probably the most common lock-up period is six months.
17:57Some firms are willing to take the risk of pricing the shares too high
18:00and being unable to sell all of them.
18:03That would be bad because the firm won't raise the right amount of money.
18:07These firms enter a best efforts arrangement with the underwriters.
18:11The underwriter promises to make a serious effort to sell the entire issue.
18:16This keeps the risk of the sale with the issuing company
18:19instead of putting it on the underwriters.
18:22That's good for the underwriting syndicate.
18:25The bad news for the underwriting syndicate is that its fee is usually fixed.
18:29It can't benefit if the offering is a huge success.
18:34Some firms, though, aren't willing to leave the possibility of a failed offering to chance
18:38and want to transfer that risk to the underwriting syndicate.
18:42They want to know for sure that they're going to sell all of the shares at the offering price
18:47and get a specified sum of money out of the deal.
18:51Underwriters will agree to that, for a bigger fee, of course.
18:55They might enter a firm commitment and purchase all the securities directly from the issuer
19:00for sale to the public at the price specified.
19:04Or they might choose a standby agreement in which the underwriter agrees to buy all unsold shares
19:11at the subscription price.
19:12They amount to the same thing, and in fact, the terms get used interchangeably sometimes.
19:18In both cases, the underwriting syndicate can end up eating stock, as they say on the street.
19:26Investment banking firms understandably hate to eat stock.
19:30In its IPO on June 28, 2013, technology products retailer CDW had to cut the offering price of its shares
19:41to $17 from its expected range of $20 to $23 per share, right before the IPO.
19:48And that's just part of the story.
19:51CDW also reduced the number of shares offered by about $3.5 million.
19:56Coupled with the price reduction, that means that the IPO proceeds fell short of expectations
20:02by somewhere upwards of $150 million and as much as $240 million.
20:10Let's look at CDW's IPO a little more closely.
20:14Documents that CDW's underwriting syndicate prepared said that CDW estimated that it would net about $370 million.
20:24CDW did something very smart in those documents.
20:29It listed how it planned to use the proceeds.
20:33It would use $344.2 million to redeem two debt issues
20:39and would also pay accrued interest on other securities.
20:44Telling investors how you plan to use the proceeds of a security issue is a good idea.
20:51That lets them decide whether or not they like the idea and want to participate.
20:56That's much better than saying the issue is for general corporate purposes.
21:01Hey, a raise and a company car for me are both general corporate purposes, right?
21:08But you probably wouldn't want to buy securities if the proceeds will fund my raise and my car.
21:13General corporate purposes sounds so much better.
21:19Investors have learned not to play those games unless they get a steep discount on the shares.
21:25Unless you want to sell your IPO shares at a steep discount,
21:29tell the buyers exactly what you'll do with the proceeds.
21:33The reports filed shortly after the IPO showed that CDW used three lead underwriters,
21:40and the names are familiar, Barclays Capital, Goldman Sachs & Company, and J.P. Morgan Securities.
21:47The rest of the underwriting syndicate contains some familiar names, too,
21:51including Bank of America Merrill Lynch, Morgan Stanley,
21:55the German powerhouse Deutsche Bank Securities,
21:58and several relatively smaller players, including the Williams Capital Group and Loop Capital Markets.
22:04If we kept looking through CDW's reports, we'd see that the transfer agent was American Stock Transfer & Trust Company.
22:13A transfer agent records people and institutions that own a company's stocks and bonds.
22:19Usually, companies outsource this to a specialist.
22:22American Stock Transfer & Trust is one of the major players in this area.
22:28Next, we might see several housekeeping items, like the company name, address, phone, and website.
22:36We'd learn the share price for sure.
22:39For CDW, it was a disappointing $17.
22:42Only 23,250,000 shares were offered,
22:46and they brought in a disappointing $395,250,000.
22:53No current shareholders sold shares as part of CDW's IPO.
22:59That's good.
23:00Insiders usually know more than others about the value of their company.
23:05In general, if insiders are selling, then I'm not buying.
23:10Sales by existing shareholders are less important for IPOs
23:15than when a public corporation sells additional shares, though.
23:18In those offerings, called seasoned equity offerings,
23:23the share price tends to fall by more than 3%
23:26because the market sees that the current shareholders want out.
23:30Usually, letting insiders add their shares to either an IPO or a seasoned offering is an expensive perk.
23:38CDW didn't make that mistake.
23:41The documents for an IPO also list the number of shares outstanding after the offer
23:46and contain two bits of industry jargon, the lock-up period and the quiet period.
23:51Remember the lock-up provision?
23:53In CDW's case, the shares sold in the pre-offering phase
23:57couldn't be resold for a 180-day period that ended on December 24, 2013.
24:06The quiet period expired on August 6, 40 days after the offering.
24:12The SEC imposes a quiet period because it thinks companies might try to hype their stock to drive up the
24:18price.
24:19No promotional publicity allowed.
24:23CDW and its underwriting syndicate seem to do most everything right,
24:27but the offering still can't be called a smashing success.
24:32CDW had to scale back the size of the issue and the offering price.
24:37What happened to the share price that day?
24:40It closed at $18.37, up about 8% from the offering price.
24:46That sounds like a good return for one day, and it is.
24:50But remember, just a couple of days earlier, the expected range was from $20 to $23.
24:57Settling at $18.37 is a disappointment,
25:02especially when we see what happens to the typical IPO later.
25:05Some other companies that went public about that time didn't do too well either.
25:10In hindsight, CDW went public at a bad time.
25:16Investors who participated in 3Com's IPO of its Palm division on March 2, 2000
25:22were a lot happier at the end of the day.
25:25Palm was riding high because its latest device, the Palm 7 Series,
25:30could actually, get this, access the Internet without using wires.
25:38Palm expected to offer it a price between $30 and $32,
25:42but it actually offered at $38.
25:45It jumped almost immediately to $145 per share
25:50before closing at $95.06.
25:53At $95.06, Palm's total corporate market value
25:59was worth more than double the market value of Apple.
26:04Another well-known IPO is Facebook.
26:07Professors Andrei Kirilenko and Professor Andrew Lowe
26:10says that Facebook's IPO was the third-largest IPO in U.S. history
26:15when it went public on Friday, May 18, 2012.
26:21Talk about hype.
26:23In early 2012,
26:25the issue of more than 337 million shares
26:28was already oversubscribed.
26:31That meant that there was demand
26:32for more shares than Facebook would make available.
26:36If you think that CDW's and Palm's stock price behavior
26:40on the IPO day is lots different
26:42from the rest of the stock market,
26:44then you'd be right.
26:46Unlike normal stock transactions
26:48with thousands of traders,
26:50IPO prices are set by negotiation.
26:53That means that they can be off by a lot,
26:56either too high or too low.
26:59It turned out that Facebook's offering price of $38
27:02was a little too high based on the first day.
27:06True, it closed at $38.23,
27:09but it only managed that
27:11because the underwriters bought Facebook's shares
27:14after the offering
27:15to keep it from falling below the offering price.
27:19Facebook went into a long slide almost immediately
27:22and was between $20 and $25 per share
27:25for most of five months
27:27from August 2012 through the end of the year.
27:30By that measure, the offering price was way too high.
27:35VA Linux offering price turned out to be way too low
27:39to be fair on the opening day
27:41and way, way too high for a year or two later.
27:45VA Linux offered at $30 in December 1999
27:50and closed that day at $239.25.
27:54That's a return of not quite 700% in one day.
28:00That sure looks like the underwriting syndicate
28:03left too much money on the table
28:04and VA Linux got a bad deal.
28:07Yet, by 2002, it traded below $1.
28:12Yes, I said $1.
28:15Okay, that's extreme,
28:16but IPOs do behave much differently
28:20than seasoned shares.
28:24Professor Jay Ritter has studied returns
28:26on IPOs for years.
28:28During the years 1980 to 2012,
28:32there were 7,704 IPOs with data he could use.
28:37Some IPOs had bad first-day returns,
28:39but the average IPO had a positive first-day return
28:43relative to the offering price
28:45for every single year.
28:47The average of those 7,704 IPOs
28:51returned 18.6% on the first day.
28:55This pattern holds internationally too.
28:58IPOs from most countries,
29:00like Norway and Portugal,
29:02Thailand and Brazil,
29:03all seem to average big first-day returns.
29:07That sounds to me
29:08as if a good investment strategy
29:10is to get in at the offering price.
29:12On top of the economic reasons we gave
29:15for the offering price to be a little low,
29:17like investment bankers not wanting to eat stock,
29:20we have the evidence that seems to bear it out.
29:25If you do that, though,
29:27then get out soon.
29:29IPOs have a strong tendency
29:31to underperform the market
29:33during the three to five years
29:35starting the very day after the IPO.
29:39For smaller firms,
29:41those with under $50 million in annual sales,
29:45that's measured in $2005,
29:46the three-year returns are beyond bad.
29:50They're horrible.
29:52More than 35 percentage points
29:55worse than the market.
29:57For larger firms, it's not so bad,
29:59but for firms with more than $50 million in sales,
30:03the average return is still 2.5 percentage points
30:07worse than the market.
30:08It only gets worse in years four and five.
30:12I wish I could give you a good reason for this,
30:14but at this point,
30:16it's something of a mystery.
30:18In our next lecture,
30:19we'll explore some of the forces
30:21that affect stock prices,
30:23but which are out of companies' control.
30:25We'll learn that there are good reasons
30:27why investors spend so much time
30:29worrying about the national and world economy.
30:32and next time in the next lecture.
30:33We'll see you next time.
30:35You
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