More than a decade removed from the dot-com era, investors are once again reverting to bad habits. They’re chasing seemingly sexy hot IPOs (initial public offerings) as they rise ever-higher and are often the last ones left holding the bag when reality eventually sets in and these stocks steadily fall.
We’ve already seen this scenario play out earlier this year — and it’s happening again. Recall that at the end of 2011, investors were buzzing about the year’s hottest IPOs: LinkedIn (Nasdaq: LNKD), Groupon (Nasdaq: GRPN) and Zynga (Nasdaq: ZNGA).

As a reality check, I took a closer look at these business models in February of this year and concluded that only LinkedIn had the makings of a tangible business model. Both Zynga and Groupon looked sharply overvalued at the time, as investors were clearly buying into a future that may never materialize. Here’s how these stocks have done since then…

 
After the post-IPO buzz died down and additional quarterly reports rolled in, Groupon and Zynga could no longer sustain their valuations, which exceeded $10 billion at their peaks. And the selling may not be done. Groupon resorts to aggressive accounting, and it’s unclear that the company’s projected $0.75 in 2013 earnings per share (EPS) represents real profit out of this business or not. Zynga is doing its best to use its post-IPO financial strength to buy its way into long-term relevance, but as the recent sell-off in traditional games makers like Electronic Arts (NYSE: EA) tells us, you’re only as good as your last hot gaming title. It’s a bit hard for me to see upside for LinkedIn from here, but at least this is a real business model.

Another IPO bubble emerges
Investors only want to own these stocks simply because they think other investors will want to own these stocks even more. So their appeal lies in an intangible and ephemeral notion of perceived value that others hold.

And right now, a fresh crop of recent IPOs is again soaring ever higher, and the majority will eventually have to face up to the reality of quarterly reports, and not simply a game of hot potato.

To establish a baseline of what a new IPO is worth, you need to look back at the IPO pricing process. Let me give an example.

As investment bankers were preparing the final paperwork for software firm Splunk (Nasdaq: SPLK), they figured they could line up demand for shares if they were priced in the low to mid-teens. That pricing is determined by comparing a newly-public company to the valuations that are accorded to rivals, or to companies that have recently been acquired in private market transactions. The company’s bankers even prepared for the possibility that the deal would be priced as low as $8, in case demand for shares was weak.

Well, a string of IPOs had performed very well in recent months, and the asset management firms and other powerful investors that tend to buy into these deals needed to hop on the bandwagon in search of another hot stock, so they angled for a piece of the Splunk IPO. That was a wise move: Shares were priced at $16 last week and opened up in the low $30s — a magical instant 100% gain.

Make no mistake, the current share price does not reflect Splunk’s business prospects, but instead the relative scarcity of its shares. Sure, this stock could go higher, but since the bankers thought it was worth $15 to $16 by comparing it to the value of peers, Splunk would have to deliver stunning quarterly results to justify the new valuation.

This same logic applies to a group of other hot IPOs. For example, Annie’s (Nasdaq: BNNY), which makes organic grocery items, was worth less than $20 a share just a month ago when its bankers were trying to come up with a suitable stock price for the IPO. A month later, it has nearly doubled from that perceived valuation. This company has been around for more than a decade, posting moderate annual growth. Why is it now suddenly seen as a hot growth stock?

[block:block=16]Risks to Consider:  As we saw with Groupon and Zynga, these stocks can levitate for several quarters before reality settles in. And in the event of a short squeeze, their small trading floats bring additional risk if you choose to short them.

Action to Take –> These hot IPOs face a looming major hurdle: 25 business days after the IPO, the analysts that have committed to following these stocks will issue fresh research reports. These analysts tend to simply re-hash the valuation analysis that their investment banking colleagues produced for the IPO pitch books. As a result, price targets for these IPOs are often only moderately higher than the offering price. For companies like Annie’s, Splunk and others, the analysts’ initial target prices may end up being markedly lower than the current share price.

As a longer-term challenge to these hot IPOs, insiders will eventually be able to sell their hefty pre-IPO stakes, which could drive the shares down. That’s why it’s always wise to exit a stock well before the 180-day lock-up expiration expires. It was a tough lesson learned by investors in Zipcar (NYSE: ZIP), which I use to own in my $100,000 Real-Money Portfolio. The company has largely delivered on the financial goals it has established for investors, but wave after wave of insider selling has put considerable pressure on shares.

The point is, when it comes to the latest hyped IPOs, most investors are better off looking for gains elsewhere.

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