By Dave Carpenter
The buzz about IPOs has faded. The stock market’s numerous plunges in recent months saw to that.
The November launches of daily deals pioneer Groupon and online game maker Zynga, however, may help whet investors’ appetites for initial public offerings once again. If they go over well, more than 200 other companies are registered and ready to follow them to the market.
But beware of IPO hype. Amateur investors must step carefully if they want to buy a company that’s just gone public without getting burned. The process is dominated by underwriters, investment banks and institutional investors that can drive up the early price to an unsustainable level.
You have to cut through the hype and be as diligent about looking into the company as you would with one that’s been public for decades.
Without an established track record or detailed earnings history to go on, that can be tricky. For that reason, many financial experts would advise the lay investor to play it safe and steer clear of IPOs altogether.
Still, an investor with high tolerance for risk may be tempted to try to get in early on the next Google. Shares of the Internet search leader had an initial offering price of $85 for connected investors in 2004, started on the stock market at $100 and have been trading lately around $600.
Odds are against hitting a home run like that in the current market. In fact, more than half the 88 U.S.-listed stocks that debuted in 2011 are trading below their offer price.
But you at least want to avoid owning the next Webvan or Pets.com — promising online businesses that bombed and folded within months of their much-heralded IPOs a decade ago.
Here’s a look at five things investors need to know about IPOs before getting involved:
1. It helps to learn the lingo.
There are other key terms to know besides IPO and “going public,” which is shorthand for a company issuing stock to the public for the first time.
The underwriter is an investment bank or other financial firm that works with the company to determine a stock’s offering price, buys shares from the issuer and sells them to investors.
The aftermarket is where most investors purchase shares — on the open stock market — after the underwriter, clients and other insiders get first crack by buying directly from the company.
A “red herring” prospectus outlines the issuing company’s history and business plan. It got its name from the red-ink label on the cover. And a “greenshoe option,” or over-allotment option, gives underwriters the right to sell investors more shares than planned if demand is high. That not only gives investors a better chance to get in on an IPO, it makes it likelier the price will be stable in the early going rather than reflecting short-term, pent-up demand.
Investopedia has more at www.investopedia.com/terms/i/ipo.asp.
2. It’s difficult but not impossible to get in.
Average investors typically can’t get in on an IPO at the offer price (before it hits the open market). Underwriters generally allot those shares to money management firms and other favored clients.
Having a full-service brokerage account with one of the underwriters of the offering is virtually a necessity if you want to even have a chance. For Zynga, as with Groupon, the lead underwriters include Goldman Sachs and Morgan Stanley.
But that alone won’t make you a preferred client. Before opening an account, ask the broker what you need to do in order to be considered for getting IPO shares, advises David Menlow, president of IPOfn Financial Network, an independent research provider in Millburn, N.J. The final decision is still going to be at the firm’s discretion.
“It’s a rigged game,” Menlow says. “Underwriters rule the roost, and they make the rules for who they’re going to do business with.”
3. First-day investing is like rolling the dice.
You’ll almost certainly pay more for a stock on its first day of open trading than those who bought in at the offer price. During the last decade, the first market price of newly issued stocks has been an average 11 percent higher than the offer price, according to Jay Ritter, a University of Florida finance professor who has analyzed IPO data.
Beyond that, though, the price is wildly unpredictable for the first couple of days.
Among this year’s hot issues, the price of online professional networking service LinkedIn more than doubled on its debut day and that of real estate website Zillow shot up 79 percent. But both are slightly down since then. Pandora Media soared as much as 62 percent on Day One, then tumbled all the way back below the issue price by the end of Day Two.
The risk of buying a stock before company earnings and analyst reports are issued is that it’s seriously overvalued, advises Reena Aggarwal, director of the Center for Financial Markets and Policy at Georgetown University.
“There’s a difference between a great company and a great investment,” she says. “Generally, the first day after an IPO is not the time to buy it.”
4. Sales are key.
Investors shouldn’t necessarily rule out companies that have losses on their pre-IPO income statements. A key indicator to focus on is revenue or sales. But don’t confuse sales growth with profitable growth, as investors did in the speculative bubble before many dot-coms went bust in 2000.
Instead, says Menlow, look to see whether revenues are moving upward as any losses decline. How soon will it be before the company will be profitable?
Sales may be a particularly important gauge when deciding whether to invest in smaller IPOs.
A study conducted by Ritter found that companies with less than $50 million in annual sales — about half of the 7,354 IPOs from 1980-2009 — have underperformed the market by 35 percent in the first three years after going public. Companies that went public with more than $50 million in sales, meanwhile, underperformed by 2 percent.
5. The long-term outlook is poor.
IPOs aren’t usually a good match for the buy-and-hold investor, because in the long run they underperform the market.
The trend for a typical IPO over the years has been for its stock price to be higher after six months and then gradually decline to below the offering price within two to three years. About 20 percent fail within five years.
So how do you distinguish which ones might flourish?
The Federal Reserve identified two characteristics of successful IPOs in a 2004 study: The companies have been around longer than other companies issuing stock for the first time, and they’re making a profit before they do so.
Aside from those factors, hoping to hit it big with an IPO can prove to be wishful thinking.
By Dave Carpenter