Should You Be Buying What Robinhood Is Selling?

This week’s initial public offering of Robinhood Markets Inc., HOOD 50.41% parent of the wildly popular trading app, isn’t just one of the most talked-about IPOs of 2021. It’s the latest in a long series of pitches to everyday investors: Share in your broker’s wealth by buying shares in your broker.

In rare cases, such pitches have paid off big time. More often, you’d have done yourself a favour by taking roughly half your money and lighting it on fire instead.

Just as Robinhood isn’t the first brokerage to offer commission-free trading, it isn’t the first to seek to “democratize” investing or to sell a piece of itself to its own customers.

On June 23, 1971, Merrill Lynch, Pierce, Fenner & Smith Inc. became the first New York Stock Exchange firm catering to individual investors to offer its shares to the public.

Thirsty for fresh capital in a struggling stock market, Merrill flogged its shares to its own customers, tapping the firm’s “awesome recognition among that vast segment of the population,” reported The Wall Street Journal the next day. “Primarily small investors, the type long championed by Merrill Lynch, quickly purchased the entire amount.”

Nearly 400 insiders at the firm unloaded a total of 2 million shares in the offering. From its initial $28 per share, the stock shot to about $42—a 50% pop—then closed around $39. That valued Merrill at 30.5 times its prior-year earnings, much higher than the overall stock market’s price/earnings ratio of 18.7.

Less than three weeks later, Merrill announced that its net earnings had fallen nearly 50% from the prior quarter.

For the rest of 1971, Merrill’s stock lost 9.4%; the S&P 500 gained 4%, counting dividends.

In 1972, when the S&P 500 rose nearly 19%, Merrill sank 7.7%. And in 1973-74, when the S&P 500 lost 37%, Merrill’s stock slumped by 61%. In its first three full years, Merrill’s stock lost three-quarters of its value; the S&P 500 fell only 5%.

Here in 2021, Robinhood’s offering is one of several trading and investing IPOs: Coinbase Global Inc., the cryptocurrency exchange, went public in April, and Acorns Grow Inc., which helps users invest in tiny increments, said in May that it expects to go public later in the year. Since its Apr. 14 debut, Coinbase is down about 27%. Robinhood fell 8% on its first day of trading Thursday.

One of Wall Street’s oldest and frankest sayings is “When the ducks quack, feed ‘em”—meaning that whenever investors are eager to buy something, brokers will sell it like mad.

Back in 1971, that was the brokers’ own shares. Roughly half a dozen major firms sold stock to the public soon after Merrill, including Bache & Co. and Dean Witter & Co. By 1974, according to data from the Center for Research in Security Prices LLC, several of them had dealt losses at least as devastating as Merrill’s.

In 1987, Jane and Joe Investor got invited to join in on the fun of Charles Schwab Corp.’s IPO, when roughly three million of the offering’s eight million shares were reserved for employees and customers of the firm.

Unlike Merrill, which was rescued from the brink of failure in 2008 when Bank of America Corp. agreed to buy the firm, Schwab went on to generate spectacular long-term performance. Over the full sweep of time since its 1987 IPO, Schwab is up more than 26,500%, or 17.9% annualized. The S&P 500 gained less than 3,500%, or an average of 11.3% annually.

However, Schwab went public in late September 1987. Only 18 trading days later, on Oct. 19, the U.S. stock market took its biggest one-day fall in history, plunging more than 20%.

Schwab’s stock got brutalized. In their first year, Schwab’s shares fell 59.1%. After three years, the market as a whole had gained 0.6% annually; Schwab’s stock lost an annualized average of 6.9%, according to CRSP.

How many of the original buyers in 1987 stuck around long enough to reap the giant rewards that came much later? That’s impossible to know, but the likeliest answer has to be: very few.

Every once in a while, outside investors in a brokerage IPO do well.

Goldman Sachs Group Inc. began trading on May 4, 1999. If you’d bought Goldman stock in the IPO and held it ever since, you’d have earned 9.1% a year, versus 7.6% in the S&P 500, according to FactSet.

Yet Goldman was a giant then, as it is now; it was late to the IPO party because it had held on to its partnership structure for so many years. Most brokerage IPOs, like Robinhood’s, occur when the firms are younger and smaller.

That makes them typical. Companies selling shares to the public for the first time tend to be small, with minimal profits; they also require additional invested capital to sustain their rapid growth.

That’s what Savina Rizova, global head of research at Dimensional Fund Advisors, an asset manager in Austin, Texas, calls “a toxic combination of characteristics that points to low expected returns.”

On average, IPOs have severely underperformed seasoned stocks in the long run. And, history suggests, brokerages doing IPOs are better at timing the market for themselves than for you.

Berkshire began liquidating its big stake in the banking company in mid-July—and has already unloaded about 15% of its interest. The selling has been fairly aggressive and has totaled about $6 billion. (Berkshire still holds 883 million shares, an 11.3% interest worth $35 billion based on its most recent filing on Aug. 30.)

The selling has prompted speculation about when CEO Warren Buffett, who oversees Berkshire’s $300 billion equity portfolio, will stop. The sales have depressed Bank of America stock, which has underperformed peers since Berkshire began its sell program. The stock closed down 0.9% Thursday at $40.14.

It’s possible that Berkshire will stop selling when the stake drops to 700 million shares. Taxes and history would be the reasons why.

Berkshire accumulated its Bank of America stake in two stages—and at vastly different prices. Berkshire’s initial stake came in 2017 , when it swapped $5 billion of Bank of America preferred stock for 700 million shares of common stock via warrants it received as part of the original preferred investment in 2011.

Berkshire got a sweet deal in that 2011 transaction. At the time, Bank of America was looking for a Buffett imprimatur—and the bank’s stock price was weak and under $10 a share.

Berkshire paid about $7 a share for that initial stake of 700 million common shares. The rest of the Berkshire stake, more than 300 million shares, was mostly purchased in 2018 at around $30 a share.

With Bank of America stock currently trading around $40, Berkshire faces a high tax burden from selling shares from the original stake of 700 million shares, given the low cost basis, and a much lighter tax hit from unloading the rest. Berkshire is subject to corporate taxes—an estimated 25% including local taxes—on gains on any sales of stock. The tax bite is stark.

Berkshire might own $2 to $3 a share in taxes on sales of high-cost stock and $8 a share on low-cost stock purchased for $7 a share.

New York tax expert Robert Willens says corporations, like individuals, can specify the particular lots when they sell stock with multiple cost levels.

“If stock is held in the custody of a broker, an adequate identification is made if the taxpayer specifies to the broker having custody of the stock the particular stock to be sold and, within a reasonable time thereafter, confirmation of such specification is set forth in a written document from the broker,” Willens told Barron’s in an email.

He assumes that Berkshire will identify the high-cost Bank of America stock for the recent sales to minimize its tax liability.

If sellers don’t specify, they generally are subject to “first in, first out,” or FIFO, accounting, meaning that the stock bought first would be subject to any tax on gains.

Buffett tends to be tax-averse—and that may prompt him to keep the original stake of 700 million shares. He could also mull any loyalty he may feel toward Bank of America CEO Brian Moynihan , whom Buffett has praised in the past.

Another reason for Berkshire to hold Bank of America is that it’s the company’s only big equity holding among traditional banks after selling shares of U.S. Bancorp , Bank of New York Mellon , JPMorgan Chase , and Wells Fargo in recent years.

Buffett, however, often eliminates stock holdings after he begins selling them down, as he did with the other bank stocks. Berkshire does retain a smaller stake of about $3 billion in Citigroup.

There could be a new filing on sales of Bank of America stock by Berkshire on Thursday evening. It has been three business days since the last one.

Berkshire must file within two business days of any sales of Bank of America stock since it owns more than 10%. The conglomerate will need to get its stake under about 777 million shares, about 100 million below the current level, before it can avoid the two-day filing rule.

It should be said that taxes haven’t deterred Buffett from selling over half of Berkshire’s stake in Apple this year—an estimated $85 billion or more of stock. Barron’s has estimated that Berkshire may owe $15 billion on the bulk of the sales that occurred in the second quarter.

Berkshire now holds 400 million shares of Apple and Barron’s has argued that Buffett may be finished reducing the Apple stake at that round number, which is the same number of shares that Berkshire has held in Coca-Cola for more than two decades.

Buffett may like round numbers—and 700 million could be just the right figure for Bank of America.

Should You Be Buying What Robinhood Is Selling?

The popular trading app isn’t the first to sell a piece of itself to its own customers.

When will Berkshire Hathaway stop selling Bank of America stock?