Last Updated September 1998

---

-MAILS PROVIDE THE BASIS FOR this month's observations. The first asks for advice in benefiting from the IPO (initial public offering) market. After all, you're always hearing about stocks coming public and doubling or tripling in their first trading day. Talk about quick and easy money! Unfortunately, it is a lot of talk and it isn't as easy as it seems. To find out why, head for The ABCs of IPOs.

The second questioner asks if there's way to cash in on Microsoft's legal struggles with the government. The idea here is to see if there's any short-term profits to be made by either buying or shorting any of the key players (Microsoft, Netscape, Sun Microsystems, etc.). Well, there probably is, but it's beyond us. What this question did do was remind us of how remarkably stupid this whole legal action is. How stupid is it? You can find out by seeing Your Government at Work. It won't lead to any short-term trading profits, but it sure feels good to vent.

Keep those e-mails coming! Your suggestions make this a lot easier and who knows, we may cover topics your actually interested in.

The ABCs of IPOs

"Ideas are everywhere, but knowledge is rare."

-- Thomas Sowell

 

N FRIDAY, JULY 17, BROADCAST.COM first issued stock to the public at $18. It closed the day at $62.75 after trading as high as $74. Even after falling back to its closing price, it had gained 248.6% in one day. Other recent offerings including Inktomi Corp., NetGravity Inc., and Microstrategy Inc. increased by 150% or more. Somebody's making money here, and a lot of it. Couldn't you be one of them? Well, the short answer is no. If want to know why, stick around for the long answer.

Let's start at the very beginning. Companies issue stock when they need to raise cash. They've chosen this method rather than borrowing either because the cost is more advantageous (usually the situation with an established company) or they won't be able to borrow under favorable terms (usually the case with younger unproven companies). Most established companies already have stock outstanding, so when they choose to issue additional shares, it really isn't an IPO. Instead, IPOs are the realm of new, riskier companies. In fact, technicians monitor the number of IPOs as a means of divining the market top. The underlying assumption is that the greater the number of IPOs, the more speculation. Investors are willing to take on more risk when safer investments are overpriced, so there's a direct correlation between the number of IPOs and the presence of a market top.

For what it's worth, this seems to be the case now. How many of the companies mentioned above have you ever heard of? Guess how many have ever had a profit? (Hint: 0). Yet they all appreciated more than 150% in their first day of trading. If that's not speculation, what is?

Most people who buy IPOs don't stick around and wait for profits. In fact, a great deal of them sell immediately after the stock is issued. As is often the case in financial markets, it's a supply and demand thing. Demand is highest when the shares are first issued and no one is expecting earnings to support the price. At that point it's all promise. Many IPOs skyrocket in the first few trading days, only to crash and burn when investors finally start looking for earnings.

Good Things Come in Small Packages

Issuing companies use it to their advantage. It's becoming more commonplace for companies to limit the number of share issued to the public in an IPO. For example, Broadcast.com only issued 2.5 million shares representing 15% of the company while Inktomi only issued 11%. Studies have shown that companies that issue smaller amounts of stock actually fare better than those that issue more. In 1998, companies that issued below the median for IPOs have returned 29% while those that issue above the median have only returned 8%.

Besides supply and demand, there's also a perceptual issue here. Companies that issue large amounts of equity probably won't be able to come back to the market again, so must get the highest price available. Investors tend to be leery of these IPOs, fearing they may be overpriced. On the other hand, when companies issue only a small fraction of available equity, the remaining balance is usually stays in the hands of management. Investors are heartened by this since they feel ownership gives management an additional incentive to perform. Whether these assumptions are true or not, IPOs tend to represent smaller and smaller percentage of available stock.

It is Who You Know

Which brings us back to why common folk like us can't make any money in IPOs. When a company issues stock, an investment banking firm (underwriter) or group of firms (syndicate) receive the initial shares for sale to their clients. With such a limited number of shares available, who do you think gets first shot? Schmos liks us buying 100 or 200 shares in our $50,000 brokerage account? Of course not! Investment bankers make them available to their best customers -- the folks with the big accounts, or U.S. senators, or U.S. senators with big accounts. Sure, you can get a new issue, but only after its first trade and after it's run up well beyond any semblance of value.

But don't be surprised if your broker calls and offers you a shot at an IPO. Unfortunately, even then you still can't make any money. Why? Well, think about it. Why's he offering to let you in on an IPO with a limited number of shares? Are you his biggest client? Unless you answer, "Yes", there's a problem.

Odds are, the IPO's a dog. Like all stocks, there's more dogs than winners in this market. More than likely, the calling broker's firm is part of the syndicate bringing Fido Co. public. They got stuck with a block of shares that they can either keep(!) or dump on unwitting clients. Either their big clients were smart enough to turn them down, or more likely, the offer was never made to them for fear of ruining their relationship. So that leaves you, the little guy. Groucho Marx turned down a membership to a social club saying, "I don't care to belong to any club that will have me as a member." In a similar manner, you don't want to buy any IPO your broker's willing to sell you. The ones you want, you can't get. The ones you can get, you don't want. It's just that simple.

Your Government at Work

"Good intentions are not enough in the absence of common sense."

-- Indian Proverb

 

MAGINE YOU CONTROLLED THE entire air supply. Anyone who needed air (and everyone does!) would have to come to you to get it. What would you charge? Conceivably, you could charge whatever you wanted. You'd probably be happy, but all your dependent customers wouldn't be. Even in a capitalist society, it would seem reasonable that the government step in and place limits on your activities.

This is precisely how your government views Microsoft and its Windows operating system. In the words of Mike Morris, general counsel for Sun Microsystems, "As philosophical questions, it is not out of bounds to think of Windows as an essential facility. For PC makers, it's their air supply. I don't know how you can get much more essential than that." Following this reasoning, the U.S. Justice Department brought suit against Microsoft alleging the use of the Windows operating system to launch a "barrage of illegal, anticompetitive practices … to destroy its rivals and avoid competition."

Specifically, the government charges that Microsoft incorporates more and more technology into its operating system, limiting the market for competitors. This includes the browser utility, platform-specific Java coding, and even the appearance of the start-up screen when you turn on your computer. With the majority of computer users running the Windows system, Microsoft is in the position to dictate these features and pressure (if not eliminate) the competition -- at least according to the government and the competition.

Of course Microsoft denies charges of any anticompetitive practices. To hear them tell it, everything they've done since the earliest version of DOS was strictly for the good of the consumer. Sure, they've integrated a lot of functionality into the operating system, but that was simply innovation. As Bill Gates puts it, "This suit is about Micorsoft's right to innovate."

The Penalty of Success

Granted, Americans usually do turn a jaundiced (jealous?) eye toward other's success. It's awfully easy to feel a certain sense of enjoyment in seeing the tribulations of big, successful companies and the people that run them. It helps compensate, at least in a small way, for those two hours you were on hold for technical support or the last time you had to shell out $90 to the multi-billionaire Bill Gates for the latest upgrade when you had just paid him a similar amount three short years ago.

But does the Justice Department really have your interest at heart? Supposedly it does. Antitrust laws were devised to protect the consumer from the tyranny of monopolists. The government, being the white knight that it is, steps in and regulates monopolies for the good of the governed. Don't believe it? Just take a look at your utility or cable bill. See what a good job they do holding down prices? For an even better example, look at your phone bill. Remember when it was one page and comprehensible? Well that was before Ma Bell was forced to give birth to all the Baby Bells, before GTE and Sprint started slamming you, and before the invention of cryptic access charges and the like. Yeah, government did a really good job protecting you there.

The Best Case Scenario

As an alternative, Justice might require Microsoft to include Netscape's browser in the operating system. Microsoft's spokesmen quickly (and accurately) drew the parallel between this and requiring Coke to place one or two Pepsis in each six-pack. Have you ever heard of anything so ridiculous? Especially when Netscape's products are already freely downloadable -- a result of Microsoft's largesse.

If Justice gets its way, Microsoft would probably also face additional limits on the Java machine included in future versions of Windows. This would prevent the evil empire from developing the language to meet new, Windows-based needs. While they claim that the language is open to anyone and should be freely available, Sun also wants to be the sentinel deciding how it's developed. All along they've been hoping to develop a Java-based operating system to displace Windows. Attempts at totally Java-based programs have failed (just ask Corel), but they still hold out the hope. A favorable ruling from Justice would buy some time and be a major step in that direction.

Oracle and Novell will also come out ahead. If the Justice Department prevails, they'll push to narrow Microsoft's product line, arguing it will keep them from "monopolizing" related software. This should curtail Microsoft's access to the database and networking markets enabling competitors to stay in business with their inferior products. That's just what you wanted, isn't it?

Protecting the Consumer or Protecting the Competitor?

So how do you, the consumer, come out in this best-case scenario? It would probably be like a return the technology market of 5 years ago. You remember how it was then: If you chose to use Windows 3.x over OS2, Apple, or even DOS, the software would cost you about $120. But you'd first have to install DOS, another $70. Then if you wanted them, you'd have to purchase separate programs such as scandisk, disk compression, uninstall utilities, etc. Browsers were in their infancy, but you could come up with one from somewhere -- at a price. Once you installed all these programs, there'd be conflicts and incompatibilities. That was pretty standard when all the software came from different manufacturers. You didn't like it, but you lived with it. If the government has their way, you'll get to again.

It's hard to see this as a step forward, as government acting on your behalf. It's probably because they aren't. Remember the purported purpose of antitrust litigation -- the protect the consumer from monopolistic pricing? Just think how things have changed in the past five years, prices have gone down not up. That's right, Windows 98 costs about $90, not $120 plus the cost of DOS. Scandisk, disk compression, uninstall utilities and (heaven forbid!) Internet Explorer are included along with a number of other features that used to be separate and oftentimes, incompatible. By the way, this is the same price charged during the introduction Windows 95. Because of Microsoft, even Netscape is now giving away their browser. More features and the same or lower price -- this doesn't hurt the consumer, it hurts the competitors.

And so we arrive at the true basis for Justice's case: Like everything else in the current administration, it's politically motivated. The president needed to make an overture to the traditional liberal base of the Democratic party. What better way than to attack one of the most successful companies led by one of the richest men in the country. This plays right into the Democrat's us vs. them demagoguery. Senator Orrin Hatch conducts hearings into Microsoft's anticompetitive practices. It's no surprise Novell and other competing designers are headquartered in his home state of Utah. State Attorneys General need to make some political hay before elections, so come up with a suit of their own.

And we're the big losers. Zillions of our tax dollars are being wasted to hound a company whose major sin is success. If the government prevails, we'll all pay more for inferior products. It is an issue of air -- hot air.