TheStockAdvisor Advice

To IPO or Not to IPO?

Truisms?

  • If you are lucky enough to get in on an IPO, you should not pass it up
  • This is your golden opportunity to get rich quick
  • You do not need to go through the usual due diligence, after all IPOs are good investments

Not so fast! As with any investment, do it wisely and do not act on impulse.

An IPO is an Initial Public Offering, a company’s first sale of stock to the public. Typically, an IPO involves the stock from a young and oftentimes little known, if not obscure, company. These MicroCap or SmallCap companies go public in order to raise money. In so doing, the company helps itself by increasing its financial base, liquidity, prestige, and ability to attract management and make acquisitions. But, once public, the company must now share the profits, be accountable to shareholders, relinquish control over how the company is run, and disclose "secret" company information.

The process begins with investment bankers, who underwrite the IPO. After researching the company and preparing a prospectus, the investment bankers promote the company and pursue buyers. Generally, their target is not the individual investor, but large institutional investors. By carefully choosing IPOs they think will succeed, the underwriters can put aside shares for their large clients, offering substantial profits for these favored investors.

What this means to the individual investor is that if you can get your hands on an IPO, it may not be the opportunity you hoped for. Of course, there are exceptions, so do your homework before passing up what might be a good buying opportunity. If you are determined to try to get a piece of an IPO, you basically need to have an account with one of the underwriters. Check with your existing broker first, and then check the offering prospectus for a full list of underwriters.

If you cannot get in on an initial offering, it is good advice not to buy shares of an IPO on its first day of trading. More often than not, they are selling at an inflated and unsustainable price. If the stock is worth owning, it will most likely be worth owning weeks, months, or even years after the initial hype has died down.

Many IPOs will experience a price run-up immediately after they start trading, only to come down to a more rational level once the buzz dies down. One study showed that investors who bought shares of an IPO at the closing price on its first day of trading saw a 2% annual return on the investment.

On average, IPOs make bad investments. A study by two university professors a few years back looked at 4,753 IPOs and 3,702 secondary offerings made between 1970 and 1990. In the six months following the offering, IPO firms lost 1.1%, versus a 3.4% gain for matching firms that made secondary offerings. During the 20 years covered by the study, the average annual return over the five-year period following the offering was 5.1% for the new issues and 11.8% for the comparable firms.

The bottom line is you do not invest in an "IPO", but in the company being offered. And, like any other company you invest in, research them and make an educated decision on the company, not the "IPO".


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