Month: November 2013

Every time a popular tech name doubles on the first day it is publicly traded, journalists write articles about how it left too much money on the table. Today it was no different with Twitter, so I tweeted the following.

ivanhoff

Nov. 7 at 1:07 PM

The myopic dummies that say that $TWTR IPO left too much money on the table, have no idea how financial markets work.

 
I received several requests to elaborate on my words, so here it is.

Twitter sold 70mm shares at $26 and raised $1.8bn. Just because the price opened at 45 and closed there, some assume that Twitter left money on the table and should’ve raised the price. Non-sense.

First, you have to remember that IPOs are means to an exit strategy. Every private company is owned by its founders, management, employees and VCs. Before a company goes public, its Board of Directors issues shares to the entity (in this case Twitter Inc.). Most of entity’s shares are offered to the public via an IPO. The rest of the shares are owned by the mentioned insiders, but they are restricted to sell them in the next 6 to 12 months after the IPO.

Twitter sold 70mm shares out of 575mm shares outstanding, which means that its current float (number of shares available to trade) is 70mm shares. Its restricted shares (owned by Twitter’s insiders) are 505mm and they will become available to trade within the next year.

There is a reason only a small percentage of each new public company’s shares outstanding is offered – to limit the supply in order to maximize the market valuation of that company. Do you really think that Twitter would’ve got $26 a share if it sold 500mm shares?

Investment banks do a serious research in order to figure out the demand. It is often an educated guess based on extensive experience of underwriting IPOs. They have two clients – the private owners of company that is going public (usually one-time customers) and institutions that buy the IPO allocations (repeat customers). Guess which interests they are trying to cater to more?

What would’ve happened if Twitter raised its IPO price to $40? First of all, the odds are that at $40 it would have been under-subscribed or it would have become a second “Facebook”. We all remember Facebook’s fiasco from May 2012, which basically closed the doors for new IPO deals for months to come. Facebook raised a little bit more money, but as a result everyone suffered. Retail investors and institutions were burned, investment banks lost business, employees were able to sell at a lot lower prices 6 months later as Facebook’s stock was crushed.

When a stock performs outstanding in the months after its IPO, it provides a huge window of opportunity for secondary offerings – where in most cases, insiders sell their restricted shares ahead of schedule. This is their exit, this is their pay-day.

Institutions are lot more willing to buy the secondaries of stocks that gained after their IPO. Secondaries are often a necessary evil. They are organized transfers of ownership that helps to smooth out insider selling that will happen anyway.

Lastly, for the IPO market to continue to work in long-term perspective and deliver the current absorbitant valuations, you have to leave some meat on the bones for the public. Nowadays, most of the wealth is created for the founders, VCs and early employees. Companies go public a lot later in their growth cycle, when they already have serious international exposure and as a result demand higher valuation.

One of the more popular Warren Buffett’s quotes states that “time is a friend of good businesses and an enemy of bad businesses”. When it comes to swing trading, it does not matter how much cash flow is a company generating and what its current valuation is.  The main two factors that matter for swing trades, which could last anywhere between 2 and 10 days, are industry momentum and price setup.

Price setups define the risk-to-reward and the probability of a breakout (breakdown) happening, but they don’t tell you the probability of following-through and the likely size of the move. It does not matter how perfect is the technical setup that you or your software have recognized. If you are not in the right industry, you are poised to achieve inferior results as a swing trader.

Industry momentum defines the likely magnitude of the move after a breakout (breakdown) and the probability of a breakout following through. Being in a “hot” industry could be the difference between a 20% after-breakout move and a 5% move, the difference between following-through and fizzling. Having an eye for industry momentum is the single most valuable skill a swing trader could learn.

There are a few other factors that impact the magnitude of the move, but they are of secondary importance: float (the smaller, the more volatile), market cap (the smaller, the more volatile) and short interest (the higher, the bigger the move potential).

Long time ago, Keynes said that “the secret to market success is anticipating the anticipations of others”. It is easier said that done, but there is a way. There is a constant industry rotation going on in the market and if we keep our eyes open and keep our personal, irrational biases in check, we stand a chance of figuring out where is the money flowing in real time.

How do we recognize that an industry is gaining momentum? One of the most simple ways is to pay attention to the number of stocks, gaining >4% in a day to new 20-day high in one industry (new 52-week high is even better). If several stocks from the same industry are simultaneously gaining momentum and having breakouts in short-term perspective, then the odds are that money is moving into that industry.

When an experienced trader sees an industry gaining momentum, his (her) instinct is to look for the next stocks in the same industry to break out. After all, such approach makes all the sense in the world. If money is going to a certain industry, sooner rather than later it is likely to lift all “boats” inside that industry. By focusing on stocks that have not broken out yet and are still building beautiful technical bases, we could allocate money to more favorable risk-reward setups. Sounds logic, right? The curious thing here is that if you study the performance of industry-related moves, you will realize that in the majority of cases, stocks that break out first, end up outperforming substantially. The very stocks that attracted our attention to an industry in the first place; the stocks that seemed too extended for a new entry, end up outperforming. Such is the nature of the market. It is often, counter-intuitive.

The goal of every swing trader is to achieve a 5% to 30% move in a 2 to 10-day horizon. Then to repeat that multiple times over the year by risking between 0.5% and 1% of capital per idea.

A few words on position sizing:

Let’s assume that your trading capital is 200k and you want to buy a stock at 40 with a stop at 38. You are risking $2 per stock. 1% out of 200k is 2k, which is your risk per idea. Your position size is 2000  : 2 = 1000 shares.

1000 shares * $40 = 40k, which is 20% of your capital

If it goes against you, in most cases you will lose 2k or 1% of your capital.

If it goes in your favor and the stock goes to 45, you will make $5 per share or 5k, which is 2.5% of your current capital. There are different ways to exit a profitable trade, but this is a topic for another discussion.