Sexy Companies Don't Necessarily Make Good Investments

Snap Inc. (the maker of the popular social app, SnapChat) has been getting a lot of attention of late, according to a recent article in the Financial Times, and not just because of its imminent initial public offering at a time when such events are a rarity.

The article states, “It’s a company reaching out to the public markets even as it loses money hand over fist,” citing data from Dealogic that says Snap is expected to raise more money than “all venture capital-backed firms joining the public markets in 2016.”

Citing new research from Charles Lee and Ken Li of Stanford University, the article uses this as an example of an investing conundrum: those companies most likely to issue stock have a history of “negative return-on-assets, high valuation multiples, previous capital raises and ‘positive price momentum’.” Unfortunately for shareholders, the article argues, “these same companies are likely to burn the equity they’ve raised on worthless investments.” Conversely, profitable businesses with lower valuations are less likely to issue stock.

The data suggests, then, that companies most likely to raise equity are riskier than those less likely to do so, which flies in the face of standard finance theory since it also suggests that an investor might earn less money when taking more risk. Lee and Li argue that companies with “sexy” products can “lure people into repeatedly overpaying for stakes” in the hopes of buying one of the “few winning lottery tickets.” This, however, can lead investors to buying high and selling low.

While FT clarifies that “none of this means Snap shares are destined to lag a broader portfolio of stocks,” it also notes, “the academic evidence suggests the odds are strongly against it—and companies that look like it—especially if they tap the public markets more than once.”