the Greater Fool theory

a real life example of the Greater Fool theory:  Groupon (GRPN)

Groupon has been in the news again recently, as the stock makes fresh historic lows.  It closed yesterday at $4.72 a share.  The issue went public early last November at $20!

Anyone who bought in the IPO and held until now has made a loss of over 80%.  Ouch!!  Even worse, the S&P 500 is up almost 20% over that span.

what the company does

Groupon, of course, brokers mass discount coupon offers between companies and the public, in return for a (large) slice of the coupon proceeds.  The idea was/is that the Groupon offer publicity and the repeat business at full price it would generate would more than make up for the initial discount.

Sounded like a great idea.  The biggest problem, of course, is that there are no barriers to entry.  There is/was nothing stopping you or me from rounding up a bunch of relatives or friends and starting a local competitor.  And there was nothing stopping a behemoth like Google from doing the same.  In fact, serious competitors had begun to sprout up long before GRPN went public.

On top of that, GRPN had a lot of trouble creating financial statements that the SEC would approve.  Among other things, GRPN was losing a ton of money because of heavy marketing expenses, its largest cost.  The marketing was needed to get the very high revenue growth that was the firm’s main financial attraction.  But GRPN initially proposed to the SEC–unsuccessfully–that it should be able to show investors results before deducting marketing expense as its key measure of operating income.

Yes, this sounds crazy.  Apparently, though, this was the best way GRPN could see to make its financials look attractive–putting lipstick on a pig, as it were.  No surprise, then, that the company ran into problems producing accurate accounting statements even after it came public.

To sum GRPN up:

–dubious accounting (the surest sign I know of a toxic security),

–operating losses,

–a business concept that larger and better funded rivals could easily duplicate–and were already doing so.

Yikes!

Q:  Why would anyone be fool enough to buy this security?  (The underwriters had to have known all the unsavory details, but that’s another story.

A:  The buyer believes that there’s a “greater fool” out there that he can sell the stock to at a higher price.

the theory itself

That’s the essence of the Greater Fool theory.

Two parts:

1.  The buyer knows the security he’s buying isn’t worth the money he’s paying for it.  So he’s a fool to do so.

2.  But he believes he can find an even bigger fool to take it off his hands at a higher price.

GRPN trading

In the case of GRPN, as I mentioned above, the stock came public at $20.

The opening trade on 11/4/11 was $25.90.  That was the low for the day.

GRPN traded as high as $31.14, intraday, closing at $26.11.  The stock stayed above the $20 line until Thanksgiving.  And it fluctuated around $20 through early February–before starting south in earnest.

Any IPO participant who “flipped” the issue on day one made at least 29.5%.  A 50% gain was possible (although I haven’t checked the volume at the $30+ prices).

To me, the most interesting thing about GRPN is that there were plenty of warning signs of the trouble that was to come.  Any professional–especially the underwriters–would have seen this immediately.  So too would anyone who thought about Groupon for more than a minute or two.  But the offer was timed to come during a period of high speculative (read: irrational) interest in social networking stocks.  No surprise that Zynga, another obviously flawed company, came at the same time.

 

 

 

 

 

 

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