Bet on Consumers, Not IPOs

06/27/2011 11:00 am EST

Focus: STOCKS

James Stack

President, Stack Financial Management

The recent IPO mania isn't the death cry for this bull market, but it isn't the path to success, either, notes James Stack of InvesTech Research. Better to go with multinational brands in this climate, he writes.

Literally from day No. 1 in March 2009, this bull market has been forced to climb a perpetual “wall of worry”—and judging by headlines from the past week, there seems to be no end in sight.

If the bull market ended April 29, it would be the shortest bull market in 44 years. That’s not to say the final peak might not be in place, but there have not been any of the characteristic divergences that would normally precede a market top.

On the commodity side, over the past several months we’ve begun to see an easing in commodity prices. As yet, it is not a significant decline—except in the price of oil, which has fallen 18% from its recent high.

However, a sizable correction in commodity pricing pressures could perhaps be one of the most positive influences to help extend the economic recovery—just as it did in the mid-1980s, and then in the late 1990s. Of course, that is also dependent on technical warning flags remaining mostly absent along the broad indicator front.

IPO Mania Nothing New
IPO manias are common after the first couple years of early bull-market gains. By themselves, however, they do not cause bear markets—and they aren’t necessarily a sign that the end of the bull market is near.

While IPO frenzies are not a systemic risk to the market, the danger for investors is playing out in the mania itself. It’s important to realize that the most popular IPOs are designed and primed (by underwriters and insiders) to explode out of the starting gate.

By creating strong demand and an artificially high price, the insiders then create an opportunity to unload their own shares at huge profits when their “lock-up” period ends—usually after four to six months. Meanwhile, the Johnny-come-latelies, who bought after the IPO, take all the risks and potential for loss.

Remember, that for every success like Google, there are scores of IPO failures. Many new stocks languish after they’re launched, and investors often find it difficult to recover their IPO investment.

As for the latest success story, LinkedIn (LNKD), it’s down about 24% from the May 18 close, but it’s still trading at about 20 times projected 2011 revenues.

For all these various reasons, we are not an advocate of IPOs, as you are always starting at a disadvantage. The insiders, venture capitalists, and investment bankers are far more knowledgeable than you about the firm, and they obtained their shares at far less than the IPO price.

Our advice is to give these new issues a wide berth and allow them time to establish a profitable track record. If they’re worth buying, they’ll still be around. And in most cases, you’ll get another chance—probably at a cheaper price.

Three stocks to buy in this environment are in consumer discretionary and consumer staples sectors:

Darden Restaurants (DRI), the world’s largest full-service restaurant company that operates nearly 1,800 restaurants including Olive Garden, Red Lobster, and LongHorn Steakhouse.

Nike (NKE), the largest seller of athletic footwear and apparel in the world. Nike products are sold in over 180 countries around the globe.

Diageo (DEO), the world’s largest producer and distributor of alcoholic drinks.

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