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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4. Be cautious
Skepticism is a positive attribute to cultivate in the IPO market. As we mentioned earlier, there is always plenty of uncertainty surrounding IPOs, mainly because of the lack of available information. You should always approach an IPO with caution.
If your broker recommends an IPO, you should exercise even more skepticism. This is a clear indication that most institutions and money managers have passed on the underwriter's attempts to sell them stock. In this situation, individual investors are likely getting the leftovers that the "big money" didn't want.
If your broker is strongly pitching shares, there is probably a reason behind the high number of these available stocks. This brings up an important point: Even if you find a company going public that you deem to be a worthwhile investment, it's possible you won't be able to get shares. Brokers have a habit of saving their IPO allocations for favored clients, so unless you are a high roller, chances are good that you won't be able to get in.
5. Consider waiting for the lock-up period to end
The lock-up period is a legally binding contract (of three to 24 months) between the underwriters and company insiders prohibiting large shareholders from selling the stock for a specified period. Take, for example, Jim Cramer, the founder of TheStreet (TST) and a contributor to MSN Money's Top Stocks blog. At the height of TheStreet's stock price, the paper worth of Cramer's shares was in the dozens of millions of dollars. But Cramer knew the stock was overpriced and would soon come down to earth, along with his personal wealth. Because this happened during the lock-up period, even if Cramer had wanted to sell, he was legally forbidden to do so. When lock-ups expire, the previously restricted parties are permitted to sell their stock.
The point here is that waiting until insiders are free to sell their shares is not a bad strategy, because if they continue to hold the stock once the lock-up period has expired, it may be an indication that the company has a bright and sustainable future. During the lock-up period, there is no way to tell whether insiders would be happy to take the spot price of the stock.
Let the market take its course before you take the plunge. A good company is still going to be a good company, and a worthy investment, even after the lock-up period expires.
The bottom line
By no means are we suggesting that all IPOs should be avoided; some investors who have bought stocks at the IPO prices have been rewarded handsomely. Every month, successful companies go public, but it is difficult to sift through the riffraff to find the investments with the most potential. Keep in mind that when it comes to dealing with the IPO market, a skeptical and informed investor is likely to perform much better than one who is not.
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