IPOs: Proceed cautiously
When investing in new issues, consider the hype -- and the fundamentals
NEW YORK (CNNfn) - Their winning streak has been impossible to ignore. Time and time again, initial public offerings run up to record levels just minutes after leaving the starting block.
Double-digit stock gains that in another era would have been considered out of this world have become so commonplace that more than a few investors have been left wondering how they can get a piece of the action.
Although some brokerages have taken steps to open the playing field to a wider range of investors, the race for IPO profits is still largely limited to institutional investors.
"The offer price is usually reserved for specialty clients and top brokers," said Richard Peterson, market strategist for Securities Data Company. "There are starting to be some cracks in that barrier, but generally the average Jane or John will never (get access to the reserved inside price.)"
But that may not be all bad news for investors.
Behind the hype
More often than not, the eye-popping gains seen by companies such as theglobe.com and other closely-watched Internet issues are not maintained, meaning some investors are actually seeing losses -- or at least less-than-impressive gains -- after investing in these stocks.
"There is a lot of froth and fever surrounding the debuts of new stocks," said Gail Bronson, Silicon Valley startup specialist and senior analyst for IPO Monitor. "But that is not the data on which investors should determine their long-run strategies."
Because individuals rarely have access to newly offered shares until days after the stock has entered the market, their chances of getting a good deal are minimal. By the second day of trading, shares are often vastly overpriced, having been artificially inflated by first-day hype.
Theglobe.com (TGLO), for instance, is now trading in the high-teens, after jumping more than 600 percent from $9 to close at $63.50 in its first day of trading. (The company declared a 2-for-1 stock split in April.)
Even as an average, IPOs don't always come out on top. In 1997, IPOs climbed less than 9 percent from their opening prices. That compares with a 31 percent gain experienced by the Standard & Poor's 500 stock index.
Picking the right IPO
And not all IPOs are created equal.
"Some companies do in fact retain their gains while others fail and fade like a fading rocket," said Peterson.
But there is money to be made in new issues, if you know how to play the game. Early investors of Microsoft (MSFT) and Yahoo! (YHOO), for instance, have seen their stakes balloon beyond even their wildest expectations.
If you're determined to invest in an IPO, but are unable to get in at the initial price, analysts recommend caution and research.
"There is a lot of marketing and publicity that is built around these IPOs to assure they have a successful debut," said Bronson. "But invariably, they will taper off and pull back to a much lower level than the high or close of the first day of trading."
Consequently, the analyst recommends investors wait at least a week --if not several -- to evaluate how these stocks are truly performing.
A "cooling-off" period also enables investors to attain more information about the company in question. Often, this information is lacking in the weeks and months preceding a public offering.
If you are set on investing in newly-issued shares, acquire as much knowledge about the company going public as you can. This information is often initially fairly limited, but becomes more accessible after the company goes public, when analysts begin to rate and evaluate the stock.
A company's registration statement, required by the Securities and Exchange Commission, can also yield clues about the prospective value of a company. By laying out its aims and expectations, these "red herrings" might give investors an idea of what marketplace the company hopes to operate in and what type of competition may exist. Looking at would-be competitors can give investors a sense of what the company's valuation should be.
Determining your strategy
In some ways, investing in an IPO is not that different than buying any other stock.
"You should apply the same classic investment principles," said Peterson.
As with any stock, you should assess your strategy: Are you a short-term day trader or are you in it for the long run? If you are a long-term investor, you should maintain a diverse portfolio and shouldn't "bet the ranch" on one company, says Peterson.
You'll also have to ask yourself how much risk you can tolerate. For instance, will you be able to handle a 30 percent dive in the stock's value?
"These stocks can be explosive in both directions," said William Smith, president and portfolio manager of Renaissance Capital's IPO Plus Aftermarket Fund. "If a company drops 5 points, you don't know if it is on the way down from $30 to $6 or whether it's a hiccup on the way to $97."
Consequently, investors determined to put money into newly-issued shares should closely watch the company's strategies and fundamentals, says Bronson.
"Do you believe the company has built out its business to support higher valuations in the stock market? Has it proceeded from the IPO as planned?" said Bronson.
Specifically, investors need to evaluate if the company has used the capital it gained from going public in a way that benefits the company, be it building better technology, enhancing the brand name, bolstering the work force or establishing new sales channels.
"There are a lot of ways to build value and the stock price should be a reflection of the health of the company," Bronson said.
An IPO mutual fund
For the slightly weaker-stomached, a mutual fund may be a viable alternative to delving into the IPO market alone.
Renaissance Capital formed the first-ever mutual fund concentrating solely on initial public offerings in late 1997, opening the fund to retail investors in the first quarter of 1998. A $2,500 minimum investment is required.
The $20 million no-load fund, dubbed the IPO Plus Aftermarket fund (IPOSX), uses its status as an institutional investor to snap up newly-issued shares, whose gains it can then pass on to average investors.
"We're in their fighting it out with all the other institutions for the (offering price) allocations," said Smith. "But as an institution, we have a much better chance of winning that battle than an individual alone does."
Although the fund does not buy shares with the aim of "flipping" them -- selling stock the day after high-flying debuts to realize big gains -- it does completely turn over its holdings about every year.
And the fund does not limit itself strictly to IPOs, purchasing stocks even after their debut if fund managers believe they are a good long-term value.
It also does not focus strictly on the widely-hyped Internet sector, although Smith concedes that about 20 percent of the funds' holdings are in Web companies, including E*Trade Group (EGRP) and the much-coveted Priceline.com (PCLN).