It wasn't supposed to be this way.

Facebook sold shares to the public for the first time on May 18. As the most highly anticipated public offering since Google went public in 2004, Facebook initially filed to sell 340 million shares at a price between $28 and $35 per share. Investors clamored to buy shares hoping for a first day blowout like the one that sent LinkedIn soaring 105 percent from its initial offering price to its first day closing price.

This outsized demand led Facebook to increase the number of shares for sale and the offering price. By the time deal was done, 421 million shares were sold at $38. None of the additional 81 million shares were sold by the company. Instead, the extra shares were sold by insiders eager to get out while the getting was good.

And who can blame them? At $38 per share, Facebook had a market value of $104 billion, or a cool 100 times trailing earnings. As investors in Yahoo, Cisco, AOL, etc. can attest, the chances of making money from such a lofty valuation are long indeed. Making matters worse, Facebook's revenue and earnings in the first quarter of 2012 were lower than those in the fourth quarter of 2011. In fact, just before the offering, General Motors announced it was pulling $10 million of ads off Facebook because they were ineffective.

In dumping so much stock on the public at such a high price, Facebook violated two cardinal rules of Wall Street IPOs. The first rule is to sell a small number of shares at a low price. This helps ensure a big first day pop that creates a bandwagon effect. A close 50 percent or 100 percent above the offering price gives the illusion that your stock is a "must own" commodity. Three months or six months down the line when the "lock up" period expires and insiders are free to sell their remaining shares, you can cash out without making your initial public owners look like chumps.

The second rule is "leave them wanting more." IPO investors habitually get a fraction of the shares they request. Thus, a big institution that wants to buy 500,000 shares might put in an order for one million shares or more. Facebook filled these orders in full. Investors suddenly found themselves in the position of Groucho Marx who famously said, "I don't want to belong to any club that will accept people like me as a member." Getting more shares than they wanted and realizing that everybody else on the Street was getting more as well, the selling began in earnest. First day volume was 566 million shares.

One might understand Facebook's behavior if the biggest benefits of the high price and additional shares went to the company rather than insiders. But the eagerness of Zuckerberg and company to personally sell, sell, sell does not bode well for new investors "friending" this stock.

Jeffrey R. Scharf is president of Scharf Investments. Contact him at jeffrey@scharfinvestments.com
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