Do's and Don'ts of IPO Investing
It is never a good idea to invest on hunches, rumors, or 'hot' tips when buying the stock of publicly traded companies. Similarly, it's risky to go 'all in' on stocks that just gained listing on a stock exchange via an IPO without first doing your homework.
Today I'll show you how to avoid buying those IPOs that could put a hole in your pocket, and instead tell you what to look for in a potentially profitable IPO investment.
You really need more caution than bravado when it comes to IPO investing - because you're putting your chips on the table with some of the biggest movers in the marketplace: the Wall Street investment firms who launch the IPOs, a slew of Wall Street traders looking to get in and out for quick gains, institutional investors, and of course independent investors. All groups are looking to make money, and that means there will be winners, and losers.
So I've been following the IPO market fairly closely recently as the number of new stock offerings picks up. In last week's issue of Small Cap Investor Daily, The IPO Market: Turn Up the Heat in 2010, I mentioned that already in the first two quarters of 2010 66 companies have gone public, compared to 69 in all of 2009. I also introduced you to Tesla Motors (Nasdaq: TSLA).
Tesla went public at the end of June, offering shares to investors at $19 each. The stock price surged to over $30 in its second day of trading, but has recently pulled-back to settle at $18.14 as of yesterday's close. I recommended passing on this stock two weeks ago in Electric Cars- The Future or a Distraction.
Only time will tell how this newly public company will do. My point today isn't to toot my horn, or justify my decision to pass. The decision won't be proven right or wrong for several months, at least. I bring up Tesla's IPO because it illustrates that volatile price action is symbolic of the risk to investors of jumping in on an IPO.
We need to be aware of the risk of investing in IPOs, and complete due diligence just like we do before buying shares of a company that's already been public for some time. I can't emphasize this point enough - if you're going to be a successful IPO investor you have to buy solid companies at fair valuations, just like you would with regular companies.
So if you want to be a player in the IPO market, what should you watch out for?
***First of all, beware of the excessive cash-out by company founders and existing shareholders (remember that even private companies have shareholders). By completing an IPO, executives and current shareholders can cash-out of their business while making tons of money in the process. They make millions and early investors in the IPO can bear the brunt if the stock price drops below its initial offering level.
Don't get me wrong, executives certainly have the right to cash-out - they took the risk to start the business and worked hard to turn a profit. They may just want to move on to bigger and better things. And shareholders of the private stock also have the right to cash-out - that potential is what fuels the venture capital industry and spurs entrepreneurship.
My point is that if you're investing in IPOs, you should take a close look at what executives and founders are doing next, and where the proceeds of the IPO are going. If executives' goals aren't aligned with new investors' interests, it could come back to haunt the company, and its stock price. And if the IPO proceeds just go to the private shareholders, then the company really isn't bringing in any 'new' money to use for expansion initiatives.
***Second, watch out for the stock rally, and subsequent crash. Some investors make huge profits on IPOs in the first two weeks (or even the first two days) only to see their gains go down the drain as the stock price plummets back to earth.
We've all seen examples of this IPO hangover, and you never want to be on the losing end. Take Tesla for example - its stock jumped 60 percent in its first day and a half of trading. Then the stock fell for each of the next four consecutive days, losing nearly 43 percent of its value.
The same thing happened with CBOE Holdings (Nasdaq: CBOE). After its IPO on June 15 the stock price jumped from $32.80 to $34.18. But in recent trading shares have fallen to close yesterday at $27.85. Despite a recent broad market rally, the stock is down 15 percent from its initial offering price.
***Third, investors in IPOs should understand the underwriting process because this is where the real money is made. There are a couple of different methods - investment banks can either underwrite the IPO on a firm commitment or best effort basis.
The difference is critical to understand because it suggests the level of confidence the underwriting firm has in the potential for share price appreciation. If you're a poker player, consider this to be the underwriting firm's 'tell'.
If the investment bank does a firm commitment offering, they purchase shares from the company and then attempt to resell them to institutional and individual investors at the full public offering. Investment banks usually purchase these shares at a discount, and profit from the spread between the purchase price and their resale price (usually around 7 percent). By buying the shares, they take on some of the risk.
In sharp contrast to the firm commitment offering, the best-efforts offering does not require an underwriting firm to purchase shares.
In this scenario the investment bank agrees to give its 'best efforts' to sell some predetermined number of shares, within a minimum and maximum range. If the investment bank falls short of this range, it can simply return the unsold shares to the issuing company. In other words, the underwriting firm is not on the hook for getting all the shares out the door.
The question you should ask is: if the underwriting firm isn't confident in the potential to sell all the shares, do you want to buy any? Investment banks are generally full of pretty darn smart people (despite the problems they've gotten into lately). If these guys are not willing to take on the risk of buying shares because of uncertain demand, you want to pick up on the 'tell' signal - and may want to pass on the stock.
***Now, don't be completely turned off by these potential
pitfalls to investing in IPOs. There are strong companies out there that have
the potential to grow their company through the IPO proceeds, and the share
price should follow.
Of course, you want to know how to distinguish the potential winners from the losers. The good news is that the information to distinguish between the two is public - the bad news is that it takes a little time to sift through.
Before a company can offer its shares to the public it must file a registration statement with the SEC. This form is known as a Form S-1 (or a Form F-1 for foreign issuers). The first part of that statement is the firm's prospectus - this is where you can find all the details on the company, including whether an IPO is a firm commitment underwriting or a best-efforts offering.
To find a company's prospectus simply go to the Filings & Forms section on the SEC website and search for the company you're interested in. As an example, I've linked Tesla's prospectus here.
Although it may be long, sifting through the Form S-1 will enhance your investment decision. You wouldn't (or at least shouldn't) invest in a company without first checking out its quarterly (10-Q) and annual (10-K) SEC filings - so why would you invest in a newly public company without first checking out the same information?
***Once you get to the prospectus, the same rules of the road apply. We're looking for revenue growth, earnings growth, solid management, etc. We also want to know how the company plans to use the IPO proceeds.
Distinguishing between the potential winners and losers with IPOs seems difficult, but not if you simply return to investing basics. Companies make money by developing a strong business model, executing a solid strategy for growth, and mitigating risks to their lines of business.
Pick up the prospectus and all this information is available to you. You can then make an educated investment decision, and avoid investing solely on hunches and rumors.
It will tell you what products the company sells and who's buying those products. It will give you information on the management team and the company's outlook. Consider it to be just like Yahoo! Finance, or Google Finance - just not as quick to read and not wrapped up with a little bow on it like those financial websites. You need to do the work yourself.
