Looking for a Hot IPO?
Look for a company with a distinct competitive advantage in a growing sector.
Initial Public Offerings are intriguing, but for most retail investors, they're as untouchable as that blonde in the Thunderbird from American Graffiti.
Don't be seduced by the prospect of heady returns or dazzled by investing in what you hope is The Next Big Thing. Think long and hard before putting your money into an IPO because with a little effort you can find less risky investments with steady returns.
Remember that institutional investors have more information about the market and therefore greater insight into the company's prospects than most retail investors. This makes mutual funds, Exchange Traded Funds and bonds attractive to The Little Guy – or it should.
"Another risk is that new markets can shift quickly," says Tom Taulli, co-author of Investing in IPOs, Version 2.0 and founder of DealProfiles.com. "Take a look at the recent IPO of Limelight Networks (LLNW). It looked like a 'can't miss' deal until its main rival, Akamai Technologies (AKAM), fought back. In other words, individual investors should put only a small portion of their money into IPOs."
If these words of caution haven't made you think about stashing your cash under the mattress, read on.
A Fool and His Money...
The IPO market is predicated on the "greater fool" theory. Here's how it works: Does it make sense to overpay in the aftermarket for the stock of a so-so company with little prospect of long-term success? Sure – if you can dump it on the greater fool and turn a quick profit.
If you want to avoid being that fool, listen up:
- Look for a company with a distinct market advantage that offers growth in a strong sector. But keep in mind that most IPOs are trading stocks, and only a handful may later develop into investments. In general, individual investors should plan to be in and out of most IPOs in three to six months.
- Let a promising IPO mature a few quarters and review the company's fundamentals before returning to the stock. Academic studies have concluded that after a steep rise in early trading, most IPOs decline in value over time. That's something retail investors know from tracking the market, and it's also largely irrelevant because no investor with an IQ larger than his shoe size tucks IPO shares in a retirement fund and forgets about them.
- Long-term, an IPO is a bet on future growth and many companies going public are in the early stages of development. This makes a price-to-earnings ratio irrelevant because companies launching IPOs often have no profits or are newly profitable. In any case, an IPO is priced to sell.
- Short-term, play the IPO cycle. Think of the first deal in a string of offers in the same sector as a stalking horse used to establish interest and set an approximate value for future deals. In many cases, the second or third company to go public is the strongest in the sector and is the deal to watch. After that, quality falls off sharply and underwriters kick out similar companies as quickly as they can in an effort to catch investor interest. By the time the junky deals flood the market, the general press has awoken to the fact that there's something going on and typically hypes ancient history. But the good deals have already come to market and anyone jumping into the sector this late in the game won't plump his portfolio.
During the 1990s IPO boom, this pattern generally held in sectors as diverse as Linux software, cigars and optical networking. Overall, it's a reliable rule-of-thumb today.
Online auctioneer eBay (EBAY) had the killer business plan and now dominates the sector. Who remembers FreeMarket, U-Bid, Fairmarkets and OnSale? The difference: eBay acted as a broker, bringing buyer and seller together to create a nationwide garage sale – and earned a fee on both sides of the transaction. The price of an item listed on eBay wasn't critical to the company's success as long as the sale went through and volume increased. In 2002, eBay acquired PayPal, an electronic payment system and solidified its position as the sector leader. Some competing online auctioneers served as dealers and bought the goods they sold, jacking up their overhead and leaving the company holding the bag for stuff that didn't sell.
The lesson: Look for a company with a distinct competitive advantage in a growing sector. A well-run company in a weak sector is a poor long-term investment. For example, the stock of McClatchy Newspapers (MNI), one of the best chains in the business, is down about 50% from its 52-week high.
The strength of the underwriter gives investors a good first read on the pedigree of an IPO. In general, major players such as Morgan Stanley (MS), Merrill Lynch (MER) and Goldman Sachs (GS) consistently deliver solid deals.
Price Is Important
Price is a solid indicator of an IPO's strength. If the underwriter increases the price range before the IPO comes to market, that shows strong interest in the deal so consider doubling your order. If the price is cut, cancel it. If the number of shares and the price per share are cut, a balsa wood plane powered by a rubber band will soar higher than the planned IPO. Such cuts are Wall Street's emphatic thumbs down – avoid the IPO.
Do Your Homework
If you plan to invest in an IPO, start by reading the company's filings with the Securities and Exchange Commission. Check how the company plans to use the money raised in the IPO. It's a good sign if the net proceeds will be used to expand the business and a red flag if the money goes into the pockets of current investors, especially top management.
Would you like to learn more? Check out Is IPO Investing For You? for a clear, detailed look into the IPO process for individual investors.
You can view the road show, the company's formal presentation to analysts and prospective investors, at RetailRoadshow.com.
Here are two top-notch books with helpful tips to new IPO investors: Investing in IPOs, Version 2.0 by Tom Taulli and Steve Harmon; IPOs for Everyone: The 12 Secrets of Investing in IPOs by Linda Killian, Kathleen Smith and William Smith.
Web sites offering solid information and insightful commentary on IPOs include IPOhome.com, IPOfinancial.com, DealProfiles.com and IPOscoop.com.
Investors with a taste for IPOs but not the stomach for manic price swings or the time to research a company may want to take a look at Renaissance Capital's IPO Plus Fund, a mutual fund devoted to IPOs.
Finally, remember that IPOs are inherently risky because you're investing in a new company that may compete in a new and undefined field, making it nearly impossible to pick winners early in the game. But like that alluring blonde in the Thunderbird, IPOs are bewitching.
For a concise, informative look at other topics that can help you improve your trading, please see Scott's other pieces: ETFs Explained and How To Read an Earnings Report.
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