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The ABCs of IPOs

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July 1, 2014
The ABCs of IPOs

Record stock markets breed initial public offerings and plenty of hype. Learn some basics to avoid getting burned by the sizzle.

It’s rare to scan your favorite financial websites these days without bumping into headlines about the latest, greatest initial public offering (IPO). Indeed, IPOs so far this year are running at the strongest clip since 2000 (remember what happened that year?). The buzz has reached the point of irrational exuberance, if you ask some analysts, who note that some of these companies are still operating at a loss. It’s important to do your own homework on specific IPOs. That said, it’s probably a good time to review some general IPO ins and outs so that education, not hype, drives your decision-making.

Nuts And Bolts

IPOs tend to accelerate during strong markets, and that’s definitely been the case lately. Through mid-May, there were about 112 IPOs by companies listing shares on U.S. exchanges, up 72% from the same period last year and the most for a comparable period since 2000, according to Dealogic (the full-year record is 814, in 1996).

Private companies go public for a variety of reasons: to “maximize shareholder value,” to raise capital to invest and grow the business, or, possibly, to use the shares as currency for a merger or acquisition.

For The Early Birds

If you want to take a stab at getting in before the stock starts trading on an exchange, check with a broker. Brokers must be part of the initial offering, and not every broker has access to every IPO. Even if your broker is participating, it can be hard to get IPO shares. While you’re at it, check your calendar as well—details on IPOs in the pipeline are accessible with just a few clicks on tdameritrade.com (see figure 1).

FIGURE 1: DEBUTANTE BALL. Expected IPO prices and other details (yellow circle) for specific dates are available on tdameritrade.com. To access the Calendar, log in to your account, go to My Account: Overview, click the Calendar tab, and select IPOs from the Event type drop-down (yellow arrows). Source: TD Ameritrade. For illustrative purposes only.

Another tactic: Identify private-equity firms and big banks that underwrite IPOs and/or provide early-stage funding for, say, a social media start-up or other type of business. Typically, these underwriters get a stake in the newly public company for their efforts, which can pay off down the road if the IPO is priced correctly and performs well. If the underwriter is publicly traded, consider the shares as a potential proxy for the eventual IPO.

At this point, there are several items to consider: the overall offering size, how many shares are available, and the general level of demand among investors. Shares of “hot” IPOs—generally high-profile companies with plenty of attention in the financial press—can be difficult to acquire in any meaningful quantity because of high demand.

So just what makes an IPO hot? The answer to that question is highly subjective and difficult to determine before the stock actually starts trading. That’s because an IPO is largely an unknown entity. Sure, a company must file a prospectus with securities regulators and supply investors with financial information before listing. But without any trading history on the public markets, or quarterly financial results, handicapping an IPO’s prospects is more art than science. Still, there are a few places to turn for guidance.

First, check whether established, reputable banks are underwriting the IPO. That list includes, but is not limited to, Goldman Sachs, J.P. Morgan, Morgan Stanley, Barclays, Bank of America Merrill Lynch, Credit Suisse, Citigroup, Deutsche Bank, and UBS. Of course, there’s no guarantee these banks will always deliver the best IPOs, but there’s a better chance of success if at least some big names are involved. Check financial media coverage, or the company’s pre-IPO regulatory filings, for information about the underwriters.

Next, analyze publicly traded competitors and how those shares are performing. If stocks of companies in the same industry are trending higher, it suggests a better chance the IPO might do well. Conversely, if competing stocks are in a bear market, then the IPO could be a dud.

There are some ways to assess the collective performance of IPOs, such as through indexes calculated by Renaissance Capital LLC;  one recent reading indicated shares of freshly-minted companies outpaced the broader market since mid-2013 (see figure 2). Additionally, there are a number of other types of investment products you could consider if you don’t have an inside track for obtaining shares in an IPO.

FIGURE 2: THE HEAT IS ON. A U.S. IPO index compiled by Renaissance Capital LLC rose nearly 35% i the 12 months ended June 30, stronger than the S&P 500 over that period and suggesting newly-public stocks outperformed the broader market. Source: Renaissance Capital LLC. For illustrative purposes only.

One more consideration: price. Accurately pricing an IPO is a challenge even for the investment banks who’ve been doing this for years. Naturally, the company holding the IPO wants a high price, while investors prefer something lower. It’s up to the banks to find middle ground. Sometimes they nail it, but sometimes they miss, badly.

Ex-Post Facto

In many cases, it may be best to just wait until after a stock starts trading— in other words, let the dust settle. Remember, once a stock is public, it’s out in the harsh, unforgiving market spotlight with its brethren. The days, weeks, and months following an IPO will reveal whether it was priced well and what kind of growth prospects lie ahead.

Some simple trading logic can be built around an IPO. Investors can simply wait for a day, or a few days, after the IPO. You can then determine potential entry and exit points based on your observations and understanding of technical analysis, as well as what’s appropriate for your risk tolerance.

Of course, the drawback of waiting for an IPO to start trading could mean you miss out on the initial pop from the offering price. But, guess what? Not all IPOs pop. Some just fizzle.

More information on investing in IPOs is available from the U.S. Securities and Exchange Commission.

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