The 16 Percent Difference
In yesterday's article, Your Weekly IPO Update, we checked in on the performance of a few IPOs and took a quick look at five new companies scheduled to go public sometime this week.
Today we'll continue on the topic of IPOs, but more specifically, we're going to look at the difference between the IPO offering price, and the opening price - the latter being the first trade execution price when the stock hits the open market. Understanding where this spread comes from - and using it to your advantage - will help you become a more profitable investor in IPOs.
When you believe an IPO is going to 'pop' and you pull to trigger an buy shares, you often feel great and believe you'll see quick gains anywhere from 20 to 50 percent in short order. Great profit potential makes IPOs really attractive to people who are willing to speculate on a company. And we saw evidence of these big gains in the chart of returns from yesterday's article.
In that chart, I calculated two returns for each IPO - and I pointed out the large difference between these returns. The first return was the return from the stock's open price in its first day of trading to its closing price on Monday. The second return calculated the stock's gain from the initial offering price to Monday's close - and in all cases was much higher than the first return. This makes sense considering that the offering price is generally much lower than the stock's open price in the market.
The chart below shows the difference between these two returns for each IPO. The average difference between the two returns was 16.1 percentage points.
Why the discrepancy? You would think that the offer price is the price you should be able to buy shares at - not so. There is one main reason for the spread...
***We know that investment banks manage these deals and help the company issue shares to the public. However, these investment banks do not hand out shares to just anybody. They tend to give the first crack at new shares to large financial institutions, such as pension funds, money-management firms, and other I-banks.
Investment banks usually make money on the IPO because they can purchase the company's shares at a discount of the offering price (around 7 percent). They then sell these shares to large institutions and brokers who then turn around and resell those shares to their clients, and to retail investors.
These brokers and financial institutions will sell the shares at a higher price so they can make a profit on the transaction. By the time the shares reach the open market, the stock price is usually significantly higher than its initial offering price.
We saw this in the 5 IPOs we covered in yesterday's article - the average 'premium' between the original offer price and the first trade on the open market was 16.1 percent.
***When demand for the IPO shares is greater than the supply (basic supply-demand fundamentals here for you econ buffs), the share price rises dramatically in the first few hours of trading - until the available shares on the market reach an equilibrium price.
A large number of IPO-hungry investors are buying a limited number of shares (demand is greater than supply) so the price increases.
With investment banks dealing with only the top institutions and wealthy investors, individual investors usually have to wait for new shares to hit the open market before they can get in on the action. At that point, it is usually too late to grab the early gains. If the stock price opens above the offering price you've already missed out on a big part of the profit potential.
I'll say it a again - in our examples above the average gain 'missed' on our five IPO stocks as of Monday's close was 16.1 percent.
***Here's the danger: if the stock opens above its offering price, individual investors usually end up buying the stock right before large institutions (those that originally bought shares) begin selling it. This practice of buying shares and immediately selling them for a profit at a higher price is known as flipping.
There is a limit to how much flipping is acceptable however - remember that business relationships are critical to ensure future deals. So, if the investment banks that were underwriters on the deal find out that institutions are dumping large amounts of the shares that they just acquired, the investment banks will probably offer them fewer shares (or no shares at all) in future deals.
The underwriting firms want to keep the stock price stable, or even better moving steadily higher. They dislike it when institutions sell large blocks of shares in the open market because they can exert downward pressure on the stock's price.
***So of course you're wondering, "How can I get in on shares of the IPO before they open higher on the first day of trading"?
All individual investors want the answer to this question because they know they can capture larger gains (16.1 percent in our example, in case you forgot!) if they could only get in early on these 'hot' deals.
Today, some brokers are trying to make shares of IPOs available to the retail investor before those shares start trading on the open market. According to TD Ameritrade, "Wit Capital, FBR.com, and Hambretcht & Quist's OpenIPO obtain shares of some IPOs that they then share with select customers…Schwab, Ameritrade, and TD Waterhouse are also banding together to offer shares of IPOs to individual investors".
However, it is unlikely that the IPO playing field will be level anytime soon. Getting in on IPOs before they start trading is still largely reserved only for large institutions, brokerage firms and their top clients.
For those 'select customers', who get shares of an IPO before it hits the market, firms tend to require that you to have a minimum balance, be an active trader, or pay for a premium service. Because IPOs can be extremely profitable, their shares are saved for the firm's biggest and most loyal customers.
***So how do we compete in this market?
My advice is this - don't fight for your shares. Consider these select clients and investment banks to be your 'partners' - even thought their really looking for you to buy their shares at a premium. Once you know what their deal is, you are armed with knowledge - and then you can act accordingly.
Be patient and wait for the stock to come down to a reasonable price. What's reasonable? Close to that first traded price on the open market.
Remember, IPOs are known for their price appreciation as soon as they hit the market. Although it may be difficult to sit on the sidelines when a new and exciting stock hits the market, it is the best play, especially if you're investing for the long term.
What do the other experts say? Kathy Smith, an analyst at IPO research firm Renaissance Capital, says "Within three months or four months the [IPO's] stock price will usually sag…A wait-and-see approach can really pay off".
You may want to wait until interest dissipates or there is a secondary offering and get in on the stock at a much lower price. This is your buying opportunity.
Now that you know what accounts for the difference between the original offering price and the stock's opening price on its first day of trading, you're armed with knowledge that can increase your chances of making money over the long haul.
If you're really interested in getting shares before they hit the market, you need to call a broker who has access to the deal. But if you're not yet a select client and don't get in on that first trade - don't panic and pay a premium.
Chances are you'll have an opportunity to get in on later, at a better price.
