Initial Public Offerings: Proceed with Caution

October 1, 2012

Initial public offerings can generate excitement. But a combination of excitement and volatility should send up caution flares for investors.

An initial public offering (IPO) is a tricky investment because no record of public trading serves as a benchmark for estimating share value. While some IPOs yield double-digit and even triple-digit returns, many others don’t, or they quickly fall back to levels far below the IPO price.

But it’s the success stories that stir the investor into exploring the possibility of investing in an IPO. For example, LinkedIn was offered last May at $45 per share and has since – as of March 2012 – traded between $55.98 and $122.70.

Potential investors need to know that an IPO is in the offing. While some IPOs, such as Facebook, are highly publicized, others are not.

A good way to find out about an IPO is by subscribing to publications that list all IPOs registered with the Securities and Exchange Commission (SEC). Once you’ve discovered a potentially attractive IPO, read the S-1 Registration Statement available over the Internet on the SEC database EDGAR.

The S-1 is a comprehensive narrative about the company. It has two basic components:

• The “prospectus,” which by law must be provided to purchasers, details key information about the company’s management history, current business operations and overall financial condition.
• The second part of the S-1 contains other information that is not required to be in the prospectus but could be important.

Carefully consider the company’s products and services. Who are its customers?

Remember that what appears on the S-1 isn’t necessarily true. If audited financials are available, ask for copies and review them carefully to verify the company’s claims about assets and other important matters independently.

Evaluate the people involved in the IPO. Do they have a history of making money for their investors? Have any of them ever violated securities or other laws? Is the underwriter reputable? Is the promoter?

If you decide to invest, the next step is to see if you can. Call the brokerage firm handling the IPO, but be prepared for rejection.

Most brokers let only their top clients buy into an IPO. Sometimes brokerage firms will let you buy shares if you establish a new account with them.

Another way to invest in IPOs is to place a limit order with your broker on the day of trading but before the market opens. A limit order sets the number of shares you will buy and the price you will pay.

If you place the order after the market opens, the price may rise above your target price. But you still may catch the stock if it dips down to your price during volatile initial trading.

Investing in an IPO requires sophisticated in-depth understanding of the business plan, the industry involved and the competition within that industry. Estimating the right price is difficult because, even if it’s a good company, you won’t make money if you overpay. So you’re estimating not only the company’s prospects but also the fairness of the price.

Conventional wisdom is that, initially, oversubscribed IPOs are likely to rise in price and undersubscribed IPOs are likely to fall in price. But, just because an IPO is oversubscribed doesn’t mean a price rise is stable.

Groupon had an oversubscribed IPO on Nov. 4, 2011, priced at $20 per share. It closed up that day at $26.11. Since then, it has been trading (as of April 2012) between $11.10 and $31.14 – more recently at the low end of that range.

Another recent IPO that illustrates potential volatility is Pandora. Pandora’s IPO last summer was priced at $16 per share and has since (as of April 2012) traded between $8.28 and $26 – more recently at the low end of that range.

Be extremely cautious about “pre-IPO” investing, which sometimes is advertised on the Internet. Pre-IPO investing involves buying a stake in a company that says it intends to go public. But the investment takes place before that company registers its IPO.

The enticement is that the investor will make a big profit by getting in early.

The SEC warns that, if such offerings are made to the general public, they may be fraudulent and illegal. Even if the offering is legal, it is difficult to liquidate unregistered stock before the company goes public – and the company may never go through with the IPO.