The Google IPO circus.

How to understand Wall Street.
Aug. 2 2004 5:58 PM

Gambling on Google

Slate bids on Wall Street's hottest IPO.

Read Henry Blodget's detailed disclosure statement  here.

The Google IPO auction process, the market's spectacle du jour, has begun. Should we join in the frenzy? Or just watch?

For reasons that will soon be clear, participating in the Google IPO auction is gambling, not investing, and the most likely outcome is a waste of money and time. If we were acting rationally, we would just decide to invest in Google (or not) after the stock started trading, when we knew what we could buy it for, rather than now, when we have to guess. Because one goal of the auction is to reduce or eliminate the first-day pop, "winning" the auction won't likely lead to the instant bonanza that usually makes people salivate about getting IPO shares. But, then again, other forms of entertainment—dinner and a show, say, or a visit to the circus—also waste money and time, and they're wildly popular.

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Because playing the Google game is probably imprudent and irrational, those interested in Wall Street self-defense shouldn't play it. But for those approaching the Google auction in the same blithe spirit that they might approach a fancy dinner, participating could be fun. Either way, it makes sense to understand a little bit about the game.

In auction parlance, Google's IPO will be a "sealed-bid, uniform-price" auction, which has different bidding incentives than other types of auctions. (For a description of how various auctions work, click here. Go ahead, click. It's interesting.) Google intends to eliminate bids it considers "speculative" and then price the IPO at or near the auction clearing price, the level at which there is enough demand to sell the shares. To "win" shares, we need to bid below the speculative price and at or above the IPO price.

Many analysts tout IPO auctions as the best thing to happen to the stock market since the reform of bubble-era research practices (see disclosure). The goals of the auction mechanism are worthy enough. It's supposed to increase fairness (and reduce cronyism) by distributing the shares to those willing to pay the most for them (as opposed to, say, those willing to kick back the biggest commissions to the underwriter), and it's supposed to get the company the highest possible price by reducing or eliminating the IPO discount.

However, it's important to remember a few things. First, auctions are not a new IPO mechanism. They have been tried in numerous countries over the last 25 years (including the United States) and, in almost all cases, have been discarded in favor of the traditional American IPO method. Second, what's good for the company (high price) is often bad for investors (less upside). Third, those willing to pay the most for shares may not be those best qualified to evaluate their worth. Fourth, and relatedly, auctions are generally not better for individual investors (i.e., us). When individuals "win" auctions (e.g., get stock), it is often because they outbid professional investors who have better information and/or a better sense of value. In such cases, the future stock performance is usually lousy, and the "winners" end up losing.

There are multiple ways we can lose the Google game, and only one way we can win. We can lose—money, time, and/or potential profits—by:

1) bidding within the "winner" range, getting shares, and having the stock drop (likely);

2) bidding so high that our bid is dismissed as "speculative," not getting shares, and having the stock rise (less likely); or,

3) underbidding, not getting shares, and having the stock rise (less likely)

The only way we can win, meanwhile, is if we bid in the "winner" range but below the price at which the stock trades in the aftermarket (highly unlikely). One reason IPO auctions have essentially been abandoned worldwide is that these odds stink. (Good thing we're not acting rationally.)

For the sake of balance, it bears noting that we will have the best odds of winning (making money, not just getting shares) if most potential bidders are so terrified of losing that they don't bid: This will allow us to aim low, get stock, and then benefit when the great prudent majority—which refrained from bidding on the auction—piles on in the aftermarket. To maximize our chances, therefore, we should preach (preferably on national television) that participating in the auction is a terrible idea. In the months since Google announced the auction, scores of experts have done this. Many of them are probably now formulating bids.

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