Buying IPO's - A primer for the average investor
- Published Nov 02, 1999
Reprinted with permission from World Finance Net IPO Newsletter, written by Irv DeGraw.
The IPO market has captured the imagination of many new investors. Lured by the promise of new industry prospects, entrepreneurial innovation, and spectacular returns, individual investors are clamoring to get a piece of this market. However, the IPO market is fast paced, unforgiving, and definitely not the place for the uninitiated. Behind the glamour of the headlines, new investors are frequently frustrated and beset by deep losses which occur at a lightning pace.
Uninitiated investors are usually attracted by the reports of spectacular first day gains. But for the overwhelming majority, these gains are a cruel illusion. Virtually all of the gains accrue on the opening price. So only those who are in on the IPO subscription realize gains. By the time an IPO reaches the trading floor (i.e., the aftermarket) theyre all gone.
Buying IPOs on the open market (aftermarket) during the first few days of trading is a prescription for disaster. During this time, prices are extremely volatile and usually fall back after a few days. So, buys are executed at market highs and rapidly erode. In fact, on average, more than 75% of all IPOs are trading under their opening price within a few months. Now, there are screaming hits, that continue to rack up gains in the aftermarket. But they are a very small minority, and, on average, represent fewer than 5% of all IPOs.
So playing the IPO market involves flirting with almost guaranteed losses. Picking those rare screamers can be done, but it's difficult work involving intense research and considerable amounts of time.
For the few investors who do invest in the research effort and find the prospective hit, the second frustration sets in. For an individual investor, getting an allocation of offering shares (i.e., getting in on the IPO offering) of a prospective hit is even more difficult. So you know theres a hit coming but cant get in on it.
However, there are some strategies that could be employed to improve the odds for the average investor. Obviously, finding the right opportunity is the crucial first step. And it begins by critically examining the offering firms "story" (i.e., products, strategy, etc.). This is easier said than done. After examining the more than 4,200 IPOs issued since 1990, its rare to find one that doesnt have a compelling entrepreneurial story. Most frequently, prospective investors "fall in love" with the firms product.
But remember that more than 76% quickly fall into the "tank". So astute investors must ignore that sirens song and do a hard-headed and cold-hearted evaluation. Weve assembled a few basic rules to help prospective investors conduct such evaluations.
The IPO market has captured the imagination of many new investors. Lured by the promise of new industry prospects, entrepreneurial innovation, and spectacular returns, individual investors are clamoring to get a piece of this market. However, the IPO market is fast paced, unforgiving, and definitely not the place for the uninitiated. Behind the glamour of the headlines, new investors are frequently frustrated and beset by deep losses which occur at a lightning pace.
Uninitiated investors are usually attracted by the reports of spectacular first day gains. But for the overwhelming majority, these gains are a cruel illusion. Virtually all of the gains accrue on the opening price. So only those who are in on the IPO subscription realize gains. By the time an IPO reaches the trading floor (i.e., the aftermarket) theyre all gone.
Buying IPOs on the open market (aftermarket) during the first few days of trading is a prescription for disaster. During this time, prices are extremely volatile and usually fall back after a few days. So, buys are executed at market highs and rapidly erode. In fact, on average, more than 75% of all IPOs are trading under their opening price within a few months. Now, there are screaming hits, that continue to rack up gains in the aftermarket. But they are a very small minority, and, on average, represent fewer than 5% of all IPOs.
So playing the IPO market involves flirting with almost guaranteed losses. Picking those rare screamers can be done, but it's difficult work involving intense research and considerable amounts of time.
For the few investors who do invest in the research effort and find the prospective hit, the second frustration sets in. For an individual investor, getting an allocation of offering shares (i.e., getting in on the IPO offering) of a prospective hit is even more difficult. So you know theres a hit coming but cant get in on it.
However, there are some strategies that could be employed to improve the odds for the average investor. Obviously, finding the right opportunity is the crucial first step. And it begins by critically examining the offering firms "story" (i.e., products, strategy, etc.). This is easier said than done. After examining the more than 4,200 IPOs issued since 1990, its rare to find one that doesnt have a compelling entrepreneurial story. Most frequently, prospective investors "fall in love" with the firms product.
But remember that more than 76% quickly fall into the "tank". So astute investors must ignore that sirens song and do a hard-headed and cold-hearted evaluation. Weve assembled a few basic rules to help prospective investors conduct such evaluations.
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- The IPO must be able to double in size, or reach approx. $100 million in revenues within 3 years. Given the heightened risks of an IPO, the offering firm simply must be able to demonstrate a sizable return. If not, it's not worth the risk. For example, a $20 million company growing at a 12% rate may be a nice operation but it would be insufficient to sustain an early valuation. So the price collapses, and you lose money.
- The IPO must be in a high growth, very large industry. Small industries and mature industries are to be avoided since they restrict the growth potential of the IPO.
- Demand in the industry must already be demonstrated (i.e., customers are already motivated to buy) with customers clearly identified. In young emerging industries, customers must frequently be educated about the value of the product concept. Investors need to have their capital used to develop the IPO’s market share, not performing good will ventures that also assist competitors. This is one reason why many pioneering ventures lose out to later entrants.
- The industry must already be highly valued by the market at IPO time. Investing in IPOs in undervalued industries, with the hope that the valuation will improve, just adds risk to an already risky situation. In addition, such IPOs quickly fade into oblivion and incur huge losses.
- The IPO’s management must have demonstrated experience running large, public companies in similar industries. We want to see a proven "been there, done that" in a similar industry. Some small company entrepreneurs successfully make the transition. Most don’t. Investors shouldn’t have their capital invested in the entrepreneur’s training.
- The IPO’s strategy must be clear, to the point, and make practical sense. Avoid offerings filled with platitudes (the most common is to provide superior customer service), blue sky plans, and overly complicated strategies. If they can’t describe the company’s goals and how they’ll be achieved in a few sentences that all can understand, they won’t be able to do it. And the stock price will go into the tank.
- Look for tangible marketing (or product distribution) alliances. Companies trying to go it alone are wasting time and investors capital. Alliances provide a jump start to rapid revenue growth and market share gain.
- The IPO’s lead underwriter must be a well known firm with a national network. This has the added benefit of ensuring analyst coverage and aftermarket support. If you’ve never heard of the underwriter, it's likely no one else has either and the deal will flop.
- Stick to firm commitment offerings. If the underwriter is not willing to put up their own money, you shouldn’t either.
- Stick to IPOs which will be listed on the New York Exchange or the Nasdaq NMS (National Market System). Smaller deals, listed on the Nasdaq Small Cap, don’t get much attention and fade fast. People only buy stocks they’re aware of and institutions can’t buy the smaller offerings.
Some new firms and online brokerages, such as Wit Capital, William Hambrecht, DLJ Direct, etc., periodically receive allocations which are made to individual investors. However, the available deals may still be subject to the winners curse, so prospective investors must be skeptical and conduct their own evaluations.
If you like an IPO but miss out on the subscription offering DO NOT buy on the first day of trading. It virtually guarantees a loss. Under such conditions we find that the best strategy is to then follow the stock during its first 2 weeks of aftermarket trading. During this time, the price will stabilize, frequently dropping back, and will reveal the direction of its valuation. On the big hits, you dont make as much. But you also avoid the "duds". So, dont be greedy. Play the odds.
Never, ever buy an IPO without reading the SEC Registration Statement (S1 or SB2 and also known as the "Red Herring"). They may be obtained from the underwriter, the offering company, or various EDGAR sites on the Internet. While the SEC does not warrant the quality of any IPO, they do ensure that all pertinent data about the firm has been disclosed. Much of what youll need to examine any IPO company will be disclosed in the Red Herring.
In over 9 years of IPO analysis we find that the auditors footnotes are particularly revealing. A big key to watch for is the auditors opinion letter. Frequently, youll find offerings with "qualified opinions", which means theres something wrong. One of the "biggies" is the "going concern" qualification. It means the auditors are uncertain that the firm can continue to operate.
Many IPO newsletters (including the WFN IPO Corner) are also available and may be used as SUPPLEMENTS to the Red Herring examination. One major rule in this area is, if after all this reading you still dont clearly understand the companys business or its prospects, avoid the IPO. Dont invest on faith.
And if you really want to play in the IPO market but dont have the time to commit to the required amount of research and analysis, consider an IPO mutual fund such as the one run by Renaissance Capital (www.ipo-fund.com).
While no set of rules or guidelines will ensure economic success, these will reduce the trauma. With these disciplines, you may miss a few stars. But youll also miss virtually all the dogs. And in the world of portfolio theory, thats a big win.
Click here for more information about the investment research and commentaries of World Finance Net. - The IPO must be able to double in size, or reach approx. $100 million in revenues within 3 years. Given the heightened risks of an IPO, the offering firm simply must be able to demonstrate a sizable return. If not, it's not worth the risk. For example, a $20 million company growing at a 12% rate may be a nice operation but it would be insufficient to sustain an early valuation. So the price collapses, and you lose money.
