How to Win With the Twitter IPO

BALTIMORE (Stockpickr) -- Want to win with the Twitter IPO? Then stay the hell away from it.

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Twitter got investors excited last week when it announced -- via Twitter, naturally -- that it had filed an S-1 with the SEC, the first step to an initial public offering. Look, I get the excitement. Twitter has been a revolution in how we communicate, with more than 200 million users blasting out rapid-fire comments 140 characters at a time.

Twitter has helped spread news in warzones, and it's helped spread celebrity gossip on kids' cell phones. It's also become a bit of a phenomenon in the investment world; brevity counts for traders, so the 140-character limit works perfectly for broadcasting trading ideas. Some funds are even using Twitter data to drive trading algorithms right now.

But none of that changes the fact that you shouldn't buy Twitter on day one. It makes sense to avoid this stock, just not for the reasons you think. Let me explain.

Not a Bad Model

First of all, Twitter doesn't have a bad model. Really.

There's one very simple sniff test that I use when I look at social media stocks: Does the company earn its revenue by helping its end users find what they're looking for?

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LinkedIn (LNKD) is a perfect example of that: The professional network gets 75% of is revenue paid for by users who are posting open jobs or looking for jobs. In other words, it makes money by helping users do what they came to the site to do. And LinkedIn has been the poster child for successful post-IPO performance; shares are up 167% since their first trade in 2011.

Contrast that with Facebook (FB).

Facebook earns most of its revenue by distracting users from stalking their friends and getting them to click ads instead. As I see it, that makes the site inherently less valuable. (For its part, FB has been changing that in recent quarters -- but we're not talking about Facebook today).

Twitter's core ad revenue is more in line with the point of the microblogging service; discovery is an integral part of Twitter (far more than at FB), and advertisers are paying for the privilege. Even better, around half of Twitter's ad revenue is coming from mobile ads right now, a metric that Facebook previously caught heat for missing.

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In other words, Twitter's business isn't the problem here. Its stock is.

No Bargain Here

First of all, I don't know many of Twitter's specifics -- few do. Because the firm is still below the $1 billion revenue watermark, it was able to file a confidential S-1 with the SEC. I'm not going to try to guess any of the numbers either.

The fact is that it doesn't really matter.

As I write, the broad market is sitting atop all-time highs, fallout from the Fed's unexpected call not to taper the stimulus money they've been pumping into the economy for the last five years. There's no question that we're in a bull market right now. And while bull markets are great for venture capitalists trying to exit an investment via the public markets, they're less great for bargain-seeking investors.

The last two times Twitter shares were auctioned in the secondary market, the auctions were oversubscribed. There wasn't enough supply to fill demand -- and remember, we're talking about "sophisticated" institutional and accredited investors, not individuals.

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But Twitter is a very public product. And as a result, there's going to be strong demand from retail investors too. The same thing happened with Facebook when it went public in the summer of 2012. Individual investors were telling news reporters that they were ready for their chance to buy Facebook "on the ground floor."

Let's get one thing straight: As an IPO investor, you're never buying on the ground floor. You're buying on the top floor, and hoping that the company keeps building floors above you.

That's a critical difference.

By any conventional valuation metric, Twitter's shares are going to be expensive. Recent private bids from hedge funds put the firm's valuation at a reported $14 billion. That's a big price tag for a firm that grossed $350 million in 2012, even if it's growing at a breakneck pace.

By itself, that's not a deal breaker -- there's nothing stopping an expensive stock from becoming more expensive if the technicals are strong. But as an IPO name, Twitter hasn't established any technicals yet.

That's what poses the biggest risk to investors who try to buy on day one.

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A high-profile company can easily score the excitement to get oversubscribed at a hefty IPO price, only to face a vacuum of buyers when dropped into the liquidity of a major stock exchange. Just look at what happened to Facebook -- it took more than a year for first-day buyers to get back to breakeven, and that's with the help of a historic equity rally pushing at its back.

Even LinkedIn buyers could have fared better by waiting six months; holding out for that time period would have nearly doubled LNKD's upside through today.

For the record, I'm not against IPOs. The portfolio I manage at my day job has a position in Tesla Motors (TSLA), another high-profile stock that went public around the same time as those big social networking names. But we intentionally waited months after the IPO before pulling the trigger and ultimately were able to dramatically reduce our risk and get a much clearer picture of the fundamental and technical arguments before putting on the trade. You could say we've done pretty well since then.

Facebook, LinkedIn and Tesla aren't the exception; they're the rule.

Historically, waiting for a fresh IPO stock to establish a trading history doesn't come with a big opportunity cost -- but it does dramatically decrease the risk of buying a stock with an IPO-sized valuation. (More on that here.)

I have no doubt that Twitter is going to fetch a hefty price when it goes public sometime in 2014. And it's going to attract a whole lot of investors who want to own Twitter the Web site, not Twitter the company. Make sure you're not one of them.

We'll get a much clearer look at Twitter's business in the months ahead. If you're still hellbent on owning it, do yourself a favor and wait. In my experience, staying away is the only way to win with the Twitter IPO.

-- Written by Jonas Elmerraji in Baltimore.

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At the time of publication, a portfolio managed by the author was long TSLA.

Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to

TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

Follow Jonas on Twitter @JonasElmerraji