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IPOs
(Initial public offering)

IPOs

Some of the most spectacular and fastest gains ever made in the stock market are the result of initial public offerings, known in Wall Street parlance as IPOs. An IPO is launched when an existing company decides to sell shares to the public.

Notable IPOs of the 1990s, such as Netscape and eBay, have taken a company from relative obscurity to stellar status, virtually overnight. Those who got in early became rich. Those who got in late may have bought overvalued stocks and, consequently, taken a bath, depending on when they sold.

Many investors do well by holding on just long enough typically, not more than six months, and then selling a now pricey stock for many times its initial price. Others hang on and watch their promising find turn sour after the initial run-up.

Assessing IPOs is tough. After all, these are incipient stocks with no trading record to go by, no market perception to use as your own gauge. These days, many IPOs don't even have earnings, or the hope for profits anytime soon. Yet for those who prefer to pick stocks, IPOs are alluring rafts of profit in a choppy and uncertain investment sea. Whether you end up being richly rewarded or dashed on the rocks of poor performance depends on your skills in sizing up companies, their markets and investors' attitudes toward them before and immediately after they go public.

Info on IPOs

Go where the action is. Know where to go if you're looking for IPOs, do business only with brokers who can get shares for you. When interviewing a prospective broker, make it clear that you expect the option of IPO shares in return for a certain level of trading business. In seeking a broker who can get you into IPOs, consider only brokerage firms whose investment-banking arms have a successful record with new issues.

Numbers do tell the story.
In a prospectus, read the balance sheet first. Numbers aren't ambiguous. Many highly successful IPOs plateau or dip after several months because the mania surrounding them cannot be sustained.

Look for these things.
When researching an IPO, ensure that the company has a good growth record, a firm market niche, a clear and legitimate purpose for the proceeds, and an experienced management team.

Disregard all rumors.
The IPO field may be the most rumor-filled field of investing. As in other fields, relying on rumor can be fatal. Many a promising company has been derailed by overly rosy projections. In evaluating an IPO, discern whether the company's finances are strong enough to keep it going if profits don't come in as planned.

Who's on board?
When evaluating an IPO, see whether any brand-name companies are stock owners; this is usually a good sign.

 


Getting a Piece of the Action IPOs

The really hot IPOs are definitely not yours for the asking

Here's how an IPO works: A group of brokerage houses agree to underwrite an IPO, price the shares to probable market demand, then sell those shares to investors. When IPOs are a hot commodity, those shares go to favored customers and big institutional buyers.

The average investor can buy only after the shares hit the market, these days often at a price far greater than their initial price. So the first step is to get in a position to get a shot at an IPO. Once you're offered a slice, then you can begin to worry about whether you want in.

The way in is through your broker, but not just any broker. If IPOs are on your horizon of ambitions, you must select your broker with this in mind. This means doing business with brokerage houses that have a good record on IPOs. (As the underwriter, the investment-banking arm of these brokerages' financial firms buys and then resells the shares.) It also means choosing an individual broker in this organization who will scratch your back if you scratch theirs.

Scratching their backs, of course, means bringing them trades, buying and selling stocks through them, generating the commissions that put braces on their kids' teeth. For retail investors, this simple quid pro quo is the only way to get on the favored list of phone numbers brokers call when they have something appealing to pass out.

Many brokerages tend to nurture the widespread misconception that they have no control over whether they can get IPO shares their company is underwriting. Don't believe it. They can usually get a piece of the action, especially for their better (i.e., more active) clients.

The key, then, is for individual investors to qualify brokers with this goal in mind: If they can't get you IPOs, you don't want to do business with them in the first place.

Find out by asking prospective brokers these questions:

Do they currently get IPO allocations? "Out of 50 brokers in the office, six or seven might do IPOs. You want to know whether a broker is one of these before agreeing to trade through them."

If the answer is yes, ask them flat out: What do they need in terms of business from you for you to get on their call list when they're passing out slices of IPOs? This is the best way to avoid ambiguities and misunderstandings down the road. Instead of assuming that you'll get a shot at IPOs, it's best to reach an explicit understanding at the outset.

If you know your brokerage's underwriting arm is handling a given IPO, and your broker comes back and says no shares are available, it's probably time to find another broker.

Given the media attention to IPOs, you might think they are a license to print money. Think again. There is an axiom in the field: When you want an IPO, you can't get it. But when you get it, you don't want it.

Such is the paradoxical nature of what lies on the other side of a blind hill. The IPO game is won by those who make the most educated guess about how green that grass actually is and the informed judgments about whether an IPO is worth the asking price. Not only that, you've got to be right about whether market makers will reach the same conclusion.

The first couple of IPOs you go for will have to make sense to you in a personal, concrete way. For example, you might have seen a lot of trucks on the road from a start-up package delivery company, and this may prod you to do some research, always a sound substitute for relying on rumor in his hype-filled field.

Seek this essential information:

• What is the company's growth record? A good benchmark is 25 percent a year for the past three or four years. Make sure that the growth is the result of smarts rather than luck. For example, how was our hypothetical delivery company doing several years ago, when no one was making Web purchases? This information will yield insights as to how they'll be doing when all competitors get on the Web-goods gravy train.

• What will the company do with the proceeds? If the only thing keeping a company out of the desirable growth range is debt, proceeds from the IP0 may be all it needs to turn the corner. Similarly, if the company is new and needs the proceeds to expand, this is a legitimate use.

IPO's

Find out: Are their costs and, hence, rates competitive? Is their on-time record appealing to finicky Internet companies obsessed with speed?

• Who are the company's clients? Their big accounts speak volumes about the quality of their product. If the delivery company handles Lands' End and L.L. Bean, that's a good sign.

• Who are the existing shareholders? When companies go public, they typically offer up only a fraction of their stock. The rest is owned by those who bought into the company early on, when it was a fledgling privately held concern. If you're looking at a Silicon Valley company and you find that its early investors include brand-name venture capitalists like Sequoia Capital, and you decide the price isn't too high, then go see your broker and genuflect.

If big chunks of stock are owned by profitable companies whose own stocks you admire, these issues are worth a closer look. Who are the managers? The toughest part of assessing IPOs is the company has no track record. But the managers may, from previous roles as officers in publicly traded companies. If they've already been with some winners, this is a good omen. Those who've tasted success can often smell it from a distance.

Prospectus, Price and Performance

Do your own due diligence before buying into an IPO

Many of the items listed above will be in the offering prospectus, but good luck finding them quickly or understanding the business babble in which the information is couched. Prospectuses are often 50 to 80 arcane pages that require the skills of an accountant and a lawyer to decipher.

Prospectuses are also really scary. To avoid lawsuits from disgruntled shareholders, companies tend to list in exquisite detail every possible thing that could go wrong with their business. When you are done with the document, you may wonder why anyone would even think of buying the shares.

Summaries of the salient numbers and information (such as the identities of the top shareholders) should be available from your broker. Search the World Wide Web for reports from outside analysts and compare these with your broker's. The most important part of the prospectus, of course, isn't the words, but the numbers, those in the balance sheet.

Take a hard look and ask the question!

1. "Are the new company's finances strong enough to keep it going even if profits do not live up to expectations, or, if profit growth is on target, to provide for continued expansion?"

Regardless of how promising a company on the public launch pad may be, this does you no good if too few investors agree, impeding the stock's performance, or if too many agree too soon, escalating its opening price to the point where there's little room for share-price growth.

Of course, when your broker makes good on your quid pro quo arrangement and calls you with a recommended IPO, there is no price, only an expected range. Your ability to predict the actual opening price, as well as the stock's price movements in the weeks to come, will mean the difference between making quick money and getting stuck with a dog.

Once you have the range, try to pigeonhole your broker on what the actual level on interest will be in the investment community. Then seek more objective intelligence on this from sources like the Wall Street Journal or various services that project the opening price. One of the more affordable such services for retail investors is the IPO Financial Network. (You can download a copy of any offering prospectus there, as well.)

Whether an IPO will be under-subscribed or over-subscribed before the opening is determined by the ratio of the level of interest to the number of shares being offered. While this ratio doubtless has an effect on what the opening price will be, prudent principals in any IPO should be weighting other factors more heavily. Chief among these are stock prices of companies of comparable size in the same industry, relative to their earnings.

Based on this kind of information, the investment banking firm handling the deal recommends a public offering price at a meeting that is usually held the night before the opening. Thus, you won't have time to evaluate this price after it's set.

Instead, your advantage lies in evaluating the expected range by comparing it with those of comparable companies. If these benchmarks are priced substantially lower than the midpoint of the expected opening range, then this is a stock you probably want to stay away from. But if you deem the top of the range to be reasonable, based on comparables and your gauge of investor interest in the stock, then you may want to go for it.

If the stock tanks during this period, that is, if it dips below its opening price, consider holding on to it for a while, assuming it doesn't fall too far. But if it soars from the start and keeps rising dramatically for several weeks, you may want to consider selling after a few months.

The reason: Though they are launched by worthwhile companies, many IPOs take on a life of their own after a few days, with latecomers pushing the price higher and higher in almost manic fashion.

This is fine for those in on the ground floor (if these folks include you, remember to send your broker a bottle of booze for Christmas), but you can't expect the high price to be sustained indefinitely.

Frequently, IPOs that start out like gangbusters reach a plateau after six months or less, in part due to profit-taking from those aware that the hype that developed in the initial weeks has doubtless inflated the stock beyond its actual worth as determined by earnings.

Whatever you do, don't jump too soon, into or out of an IPO. Evaluate them carefully. If you get in and the price dips immediately, investors may begin buying it up at bargain prices, thus driving it up, assuming the company has the worth that your research revealed. If your fledgling IPO springs out of the gate, resist the temptation to sell it in the first few days. This practice, known as flipping a stock, will alienate your broker and probably cut off your access to future lucrative deals.

Please, keep all of this information in mind when buying IPOs!

IPOs

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