4/27/2012 3:34 PM ET|
5 tips for investing in IPOs
It's easy to get caught up in the excitement of a hot new stock, but you should proceed with caution. Here are 5 things to consider.
In the days of dot-com mania, investors could throw money into an initial public offering and almost be guaranteed killer returns. Numerous companies, including VA Linux and theglobe.com, experienced huge first-day gains but ended up disappointing investors in the long term. People who had the foresight to get in -- and out -- on many of these companies made investing look far too easy.
Soon enough, though, the tech bubble burst, and the IPO market returned to normal. Investors could no longer expect the double- and triple-digit gains they got in the early tech IPO days simply by flipping stocks. There is still money to be made in IPOs, but the focus has shifted from the quick buck to a long-term outlook. Rather than trying to capitalize on a stock's initial bounce, investors are more inclined to carefully scrutinize the company's prospects for the long haul.
Even if you have a longer-term focus, finding a good IPO is difficult. IPOs have many unique risks that make them different from stocks that has been trading for a while. If you do decide to take a chance on an IPO, here are five points to keep in mind:
1. Objective research is a scarce commodity
Getting information on companies set to go public is tough. Unlike most publicly traded companies, private companies do not have swarms of analysts covering them, attempting to uncover possible cracks in their corporate armor. Remember that while most companies try to disclose everything in their prospectuses, the information is still written by them and not by an unbiased third party.
Search the Internet for information on the company and its competitors, checking for financing and past news releases, as well as overall sector health. Even though such information may be scarce, learning as much as you can about the company is a crucial step toward making a wise investment. Be prepared for your research to lead to the discovery that a company's prospects are being overblown, and that not acting on the investment opportunity may be the best strategy.
2. Pick a company with strong brokers
Try to select a company that has a strong underwriter. We're not saying that the big investment banks never bring duds public, but in general, quality brokerages bring quality companies public. Exercise more caution when selecting smaller brokerages, because they may have looser underwriting standards. For example, based on its reputation, Goldman Sachs (GS) can afford to be a lot pickier about the companies it underwrites than the hypothetical John Q's Investment House.
Yet there is one positive of smaller brokers: Because of their smaller client base, they make it easier for individual investors to purchase pre-IPO shares (although this can also raise red flags, as we touch on below). Be aware that most large brokerages will not allow your first investment to be an IPO. The only individual investors who get in on IPOs are long-standing, established (and often high-net-worth) customers.
3. Always read the prospectus
We've told you not to put all your faith in it, but you should never skip reading the prospectus. It may be a dry read, but the prospectus lays out the company's risks and opportunities, along with the proposed uses for the money raised by the IPO. For example, if the money is going to repay loans or buy equity from founders or private investors, be wary. It is a bad sign if the company cannot afford to repay its loans without issuing stock. Money that is going toward research, marketing or expanding into new markets paints a better picture.
Most companies have learned that overpromising and underdelivering are common mistakes among those vying for marketplace success. Therefore, one of the biggest things to be on the lookout for while studying a prospectus is an overly optimistic future earnings outlook. Read the projected accounting figures carefully.
You can always request the prospectus from the broker bringing the company public.
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