(MONEY Magazine) – Back in 1998, Kathleen Smith and her partners at Renaissance Capital opened the first mutual fund to focus on investing in initial public offerings. Talk about good timing. Nearly 500 companies went public last year, raking in a record-smashing $93 billion, and her IPO Plus Aftermarket fund returned 115%. It's up 25% this year, but of course savvy investors know that such huge numbers cannot be guaranteed in the highly volatile world of IPOs. In fact, nearly a quarter of 1999's freshman stocks dropped an average of 30% below their offering prices by year-end. Even the highest fliers tend not to stay aloft for long. Consider this year's IPO for Palm handhelds: The much hyped 3Com spin-off shot up as high as $165 on its first day in March but recently hovered around $55. Call it an inevitable return to reality--that's definitely why Smith and her co-managers do most of their buying not on opening day but during what's called the IPO aftermarket, when they decide which companies deserve to be drubbed and which seem destined for comebacks. MONEY's Laura Washington recently spoke with Smith at Renaissance's office in Greenwich, Conn.

Q. Now that individual investors can get first-day shares online, has the process of buying into an IPO been at all democratized?

A. The traditional way of obtaining shares for an individual would have been by having a large account and a good relationship with one broker. Now there are more outlets for individuals to get shares, including the auction process, but the reality is that there are not enough shares to go around. For every 20 people who want to buy, perhaps one is able to do so.

Q. So how do you get access?

A. We beg. Actually, we don't get everything we want, but then only a small part of our returns are from buying at the offering. We don't buy and flip. That's not a way to enhance your returns. That's a way to create a big tax bill. A great deal of our returns are from good stock selection. Markets go down, and that gives us a chance to buy. And sometimes we accumulate a new position after insiders are free to sell, which often puts downward pressure on a stock.

Q. Studies from the early '90s show that IPOs tend to underperform the Nasdaq for many years. Still true?

A. Those studies are based on buying every IPO offered, and it certainly wasn't true last year. If an investor bought every new-company issue in 1999 at the first-day closing price, his after-market return would have been 69%. But that's like buying on a dartboard basis--none of it relates at all to the research approach to investing, which is what we do. We analyze every IPO, but we don't buy every one.

Q. Tell us how you decide which ones to buy.

A. We score IPOs based on four factors: two long and two short. Short-term factors include group momentum: Is it a favorable group? For example, these days wireless is a strong area; however, the momentum is against consumer websites and financial services, so we have few holdings in these areas. Second, we look at valuation. We compare the company coming public to what we think are the most similar publicly traded comparables to give us a feel as to how this new company is going to trade.

Q. And long term?

A. The two key long-term things are fundamentals and management control. The fundamentals are an analysis of the business of the company, its position in its industry and the track record it has. Then we look at who runs the company and ask: How much ownership do they have? Do the owners of the company have the incentive to do a good job--especially for the shareholders who are coming in at a higher price than management paid? If there are too many cheap shares for management, when the stock goes down 50%, it doesn't really bother them, but it's sure going to bother everyone else who owns it.

Q. Tell us: Which companies are making the final cut?

A. You know, we're not just trying to find the good ones. We look for the bad ones, then short them. Of the 90 stocks in our portfolio, maybe 15 are short.... I don't want to say which those are.

Q. Okay, then tell us where you are long these days.

A. The communications infrastructure that's being built in Japan and Europe is a promising area, and these companies go public simultaneously in their market and in our market. So we own the American Depositary Receipt for the communications company Internet Initiative Japan (IIJI), which is now trading at about $90.

Q. Where else?

A. We're also seeing a whole new market for wireless services, abroad and in the U.S. Phone.com (PHCM) makes operating systems for handhelds; it's a little bit like what Windows is to computers. It was trading for $143 in mid-March. And Aether Systems (AETH) offers wireless trading devices for Schwab and Bear Stearns customers. It's around $220. Optical infrastructure is another area we favor: Sycamore Networks (SCMR) makes bandwidth enhancers for optical networking. It's about $130.

Q. I see E*Trade is a big holding. But it went public four years ago. Is there an age limit for your IPOs?

A. We can't add positions if they're way beyond what would be considered their IPO. But there is no problem holding on to the ones that we still feel have upside and are good investments.

Q. When do you sell?

A. We'll sell our positions right away if we find that we made a mistake and misunderstood something. [See the charts below.] We tend to look at whether the opportunity is great for the company. Is there any reason why opportunities will diminish? That will make us sell.

Q. What's the big mistake folks make when they buy?

A. You may hear about a "hot" IPO in the pipeline and ask the broker to put in an order to buy it the minute it opens, no matter what the price. Many times that could turn out to be the highest price that stock will see for a long time.