The Twitter IPO: Should you buy?

Unless you live under a rock, you probably heard that Twitter just had its IPO. In English, that means you can now, for the first time, buy its stock on a stock exchange. Mere mortals (those without the insider connections to get the stock at its $26 official listing price) had to buy at an opening price of $45. After the initial surge, the price has settled back into the low 40s, and many reputable pundits (here and here) have suggested that buying Twitter as an investment might be a mistake.

Will it?

Dog years

You know how they talk about dog years, meaning you have to multiply the actual years by seven to arrive at a “normal” equivalent? Well, just as dogs have a much shorter life than humans, technology companies have a much faster life cycle and shorter lives than “regular” companies. For example, Caterpillar and General Electric have been around for eons, but does anybody still remember Digital Equipment, the tech darling of the stock market not too many years ago? Hotter than Twitter, it was. And who remembers Data General, its close competitor? Distant memories, both.

And what about Palm? Just yesterday it was the hot thing. Today its carcass, along with DEC’s, lies rotting somewhere in the Hewlett-Packard bone yard, which seems to have become the ultimate destination of tech companies when they reach the end of their lives. (Hmmm… where will HP go when its day comes? One can only wonder.) IBM, the granddaddy of all technology companies, has only survived by having more transformations and cosmetic surgery than Joan Rivers. Technology companies just face much shorter life cycles than, say, construction equipment manufacturers because the business they’re in changes at a pace never seen before.

Why does this matter? Twitter is a tech stock, and therefore likely to face a rapid move through the different phases of its business cycle… and it’s starting its publicly listed life as a money-loser. Why? Because it gives away its main product/service for free. Microsoft, on the other hand, has always charged a lot for what it sells, and it gives away nothing, except Hotmail. Therefore it has always been highly profitable. Add to that its high growth and it is easy to understand why it was a popular stock to invest in once upon a time. Apple went from the outhouse to the penthouse only when it made fantastic profits on all of its iThingies.

Earnings, the fancy word for profits, then, is the key to long-term success. But Twitter isn’t making any. Its fans would add “yet.” But this is where the “dog years” thing comes in: How long will it take Twitter to become profitable? And will it be profitable for any length of time before going to tech-stock heaven?

Stories

Until profits materialize on a consistent basis, the only reason people are attracted to a stock like Twitter is, well, stories. Stories are wonderful things and I love them myself, mainly because when I’m telling one, I get to write the script to make it say whatever I want. It’s the same with a stock story: I can spin a convincing yarn about how this hot company called Twitter will conquer the earth and achieve riches and fame to dwarf Microsoft. I could just as easily weave a delightful plot that has the company crashing and burning like Enron. At this point in time, you’d be hard pressed to choose between the two stories, because both can be very convincing. But there are still too many unknowns to know which one will play out in real life.

Warren Buffett famously stays away from stocks whose stories he doesn’t understand. And when he means stories, he means the reasons why this or that company will continue to make outsize profits. His examples are companies like American Express and See’s Candies, companies that brazenly charge more than their competitors do, have done so for decades, and look poised to continue getting away with that for eons to come. Twitter and Facebook, which don’t charge for their basic product, those are things he doesn’t understand. And, to be quite honest, most people looking at Twitter don’t understand where their profits will come from either.

Prisoner’s Dilemma

Why, then, do so many people froth at the mouth to get their hands on a stock that is clearly overpriced by many magnitudes? The answer is found in something called the Prisoner’s Dilemma, something related to game theory. In a nutshell, it says you try to guess what others will do and figure out how you can profit from that. If you think other people will want Twitter stock, then you buy it in hopes of profiting from the surge. It doesn’t matter why the other people will buy; it only matters that they will. If enough people think like you, you collectively create a rising market. The same principle pretty much drives the gold price: You buy gold if you think others will also buy and drive up the price.

You can see how the outcome for this pricing model depends on how many people take the view that others will also buy. If enough people think that way, you get a nice little bubble going. If they don’t, the price drops instead of rising.

When Facebook went public, its stock lost 20 percent of its value in the first two days of trading. In its first two days of trading, Twitter lost 10 percent after a nice initial spike. This despite an intense effort to avoid the pitfalls stepped into by Facebook last year.

Not all IPOs depend exclusively on PD pricing (Prisoner’s Dilemma). Noodles & Company, the Denver-based restaurant chain, went public earlier this year, but their shares more than doubled after two days of trading and are still there after more than three months. Main reason: The company is profitable and has a proven business model for generating profits. That means the story of its future potential is easier to believe by more people.

Of course, it is way too early to judge whether the Twitter IPO is a success or not. However, until the company generates consistent and sustainable profits, its life cycle may be shorter than hopeful investors foresee.

I’m not buying. Are you?