Pandora (P) traded on the open market for the first time yesterday.  For those that don’t know, Pandora is an internet radio company that allows users to choose an artist, genre, or song and listen to music based on their selection with limited commercials.

There was quite a bit of buzz leading up to this IPO given LinkedIn’s (LNKD) eye-popping debut last month with shares rising as much as 172% at one point in the first day of trading.  Pandora’s IPO didn’t generate quite the same excitement, but still gained 62.5% at one point before closing the day 8.9% higher.

These first day gains reflect the small number of shares offered and extremely high demand among the investing community for access to the new wave of internet companies.  For example, LinkedIn floated 7.8 million shares in its initial offering, but over 30 million shares traded hands in the first day.  In other words, each share of LinkedIn stock changed hands 3.85 times in the first day of trading.  Pandora’s ratio of shares offered to shares traded was 2.86.  To put that level of activity in perspective, that ratio for Google’s (GOOG) IPO in 2004 was 1.14 and Visa’s (V) was 0.44 in 2008.

It’s easy to be lured by the prospect of quick returns with IPOs, but investors that rush to buy shares on the first day of public trading are often susceptible to the winner’s curse.  In its simplest form, the winner’s curse says that the winner of an auction will overpay for the asset as a result of incomplete information or emotions.

(In the mathematical sense, each bidder has a different estimate of the value of the asset, but the winning bidder places a higher value to the asset than the average value of all other bidder’s estimates.  As the number of bidders increase, so does the difference between the winning bid and the average estimate of the asset’s value.)

With LinkedIn, the stock was initially offered at $45 – a price the company’s management and advisors thought was fair – but on the first day of public trading the stock closed at $94 and traded as high as $122.  Today the stock trades at about $75, so the investors that rushed out to buy LinkedIn that first day overpaid and have already suffered a loss.  The losses may get even greater considering that the company’s managers were willing to sell the stock for $45, which brings me to my next point…

The management at LinkedIn and Pandora are acting in the interest of the pre-IPO shareholders, which are primarily employees and venture capitalists.  Do you think they want to offer you a chance to buy their shares at an undervalued price?  Historical evidence strongly suggests the answer is no.

There have been studies that show IPO stocks underperform similar-sized seasoned stocks in the first five years after issue (Loughran and Ritters 1995).  You can also look at the success rate during the dot-com boom with more than 95% of those stocks failing to succeed.

I think both LinkedIn and Pandora have a good shot at surviving, but I don’t think they would make a good investment today.  The next big internet IPO on the horizon is Groupon, an online provider of coupons.  I am a big user of this service, but I’m not so sure I’d be an investor in this one either.  It is impressive that Groupon has 83 million subscribers across 43 countries, but only 16 million have actually bought a Groupon!  Google recently offered $8 billion to buy the company, but Groupon decided to go it alone and some are estimating the IPO will value the company at $15 billion.  I’d hold off in this case as well.

Thanks for reading,

Peter Lazaroff, Investment Analyst

St. Louis, MO

www.acrinv.com/blog