5 Tips For Investing In IPOs

An initial public offering (IPO) is the first time that the stock of a private company is offered to the public.

In the days of dotcom mania, investors could throw money into an IPO and be almost guaranteed killer returns. Numerous companies, including names like VA Linux and theglobe.com experienced huge first-day gains, but ended up disappointing investors in the long term. People who had the foresight to get in, and out, on some of these companies made investing look way too easy.

However, no investment is a sure thing. Soon enough, the tech bubble burst and the IPO market returned to normal. In other words, investors could no longer expect the double and triple-digit gains they got in the early tech IPO days simply by flipping stocks.

There is still money to be made in IPOs, but the focus has shifted from the quick buck to the long-term outlook. Rather than trying to capitalize on a stock's initial bounce, investors are more inclined to carefully scrutinize long-term prospects.

Even if you have a longer-term focus, finding a good IPO is difficult. IPOs have many unique risks that make them different from the average stock which has been trading for a while.

First things first, to get in on an IPO, you will need to find a company that is about to go public. This is done by searching S-1 forms filed with the Securities and Exchange Commission (SEC). To participate in an IPO, an investor has to be registered with a brokerage firm. When companies issue IPOs, they notify brokerage firms, which, in turn, notify investors. 

Most brokerage firms require that investors meet some qualifications before they can participate in an IPO. Some brokerage firms might specify that only investors with a certain amount of money in their brokerage accounts or a certain number of transactions can participate in IPOs. If you are qualified to participate in IPOs, the firm will usually have you sign up for IPO notification services, so that you are alerted when there are any new IPOs that meet your investment profile. 

If you do decide to take a chance on an IPO, here are five points to keep in mind:

Getting information on companies set to go public is tough. Unlike most publicly traded companies, private companies do not usually have swarms of analysts covering them, attempting to uncover possible cracks in their corporate armor. Remember that although most companies try to fully disclose all information in their prospectus, it is still written by them and not by an unbiased third party.

Search online for information on the company and its competitors, financing, past press releases, as well as overall industry health. Even though info may be scarce, learning as much as you can about the company is a crucial step in making a wise investment. On the other hand, your research may lead to the discovery that a company's prospects are being overblown and that not acting on the investment opportunity is the best idea.

Try to select a company that has a strong underwriter. We're not saying that the big investment banks never bring duds public, but in general, quality brokerages bring quality companies public. Exercise more caution when selecting smaller brokerages, because they may be willing to underwrite any company. For example, based on its reputation, Goldman Sachs (GS) can afford to be a lot pickier about the companies it underwrites than John Q's Investment House (a fictional underwriter).

However, one positive of smaller brokers is that, because of their smaller client base, they make it easier for the individual investor to purchase pre-IPO shares (although this may also raise a red flag as we touch on below). Be aware that most large brokerage firms will not allow your first investment to be an IPO. The only individual investors who get in on IPOs are long-standing, established (and often high-net-worth) customers.

We've mentioned not to put all your faith in it, but you should never skip reading the prospectus. It may be a dry read, but the prospectus lays out the company's risks and opportunities, along with the proposed uses for the money raised by the IPO.

For example, if the money is going to repay loans, or buy the equity from founders or private investors, then look out! It is a bad sign if the company cannot afford to repay its loans without issuing stock. Money that is going toward research, marketing or expanding into new markets paints a better picture.

Most companies have learned that over-promising and under-delivering are mistakes often made by those vying for marketplace success. Therefore, one of the biggest things to be on the lookout for while reading a prospectus is an overly optimistic future earnings outlook; this means reading the projected accounting figures carefully.

You can always request the prospectus from the broker bringing the company public. (For more, read Interpreting a Company's IPO Prospectus Report.)

Skepticism is a positive attribute to cultivate in the IPO market. As we mentioned earlier, there is always a lot of uncertainty surrounding IPOs, mainly because of the lack of available information. Therefore, you should always approach an IPO with caution.

If your broker recommends an IPO, you should exercise increased caution. This is a clear indication that most institutions and money managers have graciously passed on the underwriter's attempts to sell them stock. In this situation, individual investors are likely getting the bottom feed, the leftovers that the "big money" didn't want. If your broker is strongly pitching shares, there is probably a reason behind the high number of these available stocks.

This brings up an important point: Even if you find a company going public that you deem to be a worthwhile investment, it's possible you won't be able to get shares. Brokers have a habit of saving their IPO allocations for favored clients, so unless you are a high roller, chances are good that you won't be able to get in.

The lock-up period is a legally binding contract (three to 24 months) between the underwriters and insiders of the company prohibiting them from selling any shares of stock for a specified period.

Take, for example, Jim Cramer, known from TheStreet (formerly, TheStreet.com) and the CNBC program "Mad Money." At the height of TheStreet.com's stock price, his paper worth (of TheStreet.com stock alone) was in the dozens upon dozens of millions of dollars. However, Cramer, being a savvy Wall Street vet, knew the stock was way overpriced and would soon come down to earth, along with his personal wealth. Because this happened during the lock-up period, even if Cramer had wanted to sell, he was legally forbidden to do so. When lock-ups expire, the previously restricted parties are permitted to sell their stock.

The point here is that waiting until insiders are free to sell their shares is not a bad strategy, because if they continue to hold stock once the lock-up period has expired, it may be an indication that the company has a bright and sustainable future. During the lock-up period, there is no way to tell whether insiders would in fact be happy to take the spot price of the stock or not.

Let the market take its course before you take the plunge. A good company is still going to be a good company, and a worthy investment, even after the lock-up period expires.

By no means are we suggesting that all IPOs should be avoided. Some investors who have bought stock at the IPO price have been rewarded handsomely by the companies in question. Every month successful companies go public, but it is difficult to sift through the riffraff and find the investments with the most potential. Just keep in mind that when it comes to dealing with the IPO market, a skeptical and informed investor is likely to perform much better than one who is not.