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IPOs:
Hot, But Take Care Not to Get Burned
The investment market for initial public offerings
(IPO)s always seems to be sizzling. Almost daily, there are reports
of an e-company, bio-tech or telecommunications offering whose stock
price skyrocketed as soon as shares began trading on the market. To
the uninformed investor, IPOs are the siren song luring us to the rocks
to the tune of a sure investment and a fast way to big money.
History has shown that many IPOs never live up to their perceived reputations,
and the ones that do are usually outside the reach of the average investor.
If you’re considering purchasing IPOs for your investment portfolio,
make sure you are aware of what an IPO is, and familiarize yourself
with the risks surrounding this type of stock.
What are IPOs? An initial public offering is, as its name implies,
the first public sale of a company’s stock. A privately owned company
usually decides to "go public" to raise capital for infrastructure
or other growth related purposes.
There are a variety of complicated steps involved in taking a company
public. Here’s how the process works in a nutshell: Each IPO is
managed by one or more large brokerage firms, called underwriters. Underwriters
assist the company to prepare for the offering and complete the various
paperwork and prospectus required by federal and state securities agencies.
They also create a selling group, called a syndicate, which helps sell
the issue. The syndicate helps determine the stock’s initial offering
size and price which are often influenced by several factors including
market conditions and anticipated demand.
Once preliminary prospectuses have been provided to potential investors
and the required waiting period has elapsed, the underwriter and syndicate
sell the stock in the "primary market." The primary market
is comprised of the groups that subscribed to the stock during an initial
offering period. Participants include institutional investors such as
pension funds, mutual funds and qualified individual investors. Qualified
investors are those who have a high net worth, do substantial business
with the firm or are regular investors in IPOs. In the past, the average
individual hasn’t had access to these offerings. However, this
is evolving as the Internet and online brokerages are beginning to change
the way the process works.
As soon as the offering is completed, primary market investors are free
to sell their stock on the open or secondary market. This is where the
average investor often gets into the action. If the stock is perceived
as a hot offering, investors may bid its price dramatically higher.
Are you a trader or investor? Traders run the risk of buying high and
missing the opportunity to sell as the IPO hits its price peak, while
investors succumbing to the frenzy can get burned as IPOs flame out
when business realities set in.
What to watch out for: The best way to avoid the risk of getting
burned by an IPO, or any other stock investment for that matter, is
to do your homework. Do your due diligence research and proceed with
caution and realistic expectations. Know what your company is capable
of, where it is going, and where it has been, and have an exit strategy.
This highlights another problem with IPOs: the issue is normally made
to fund young companies unproven in the public markets. Because a company
had previously been privately held, your access to long-term financial
information as well as details about the management team may be limited
to what is in the prospectus. What’s more, the shares of small
company stocks are more volatile than those of more seasoned companies.
If you still decide that IPO investing is right for you, research the
companies you are considering as extensively as possible. This means
scouring the prospectus for such information as:
Risk factors – The company must disclose anything it is
aware of that could jeopardize its business and in turn your investment.
These factors include but are not limited to: high debt, supplier problems,
technical obstacles, reliance on too few customers or legal disputes.
Read the notes to the financial statements, they are often the keys
to understanding what the numbers mean and offer clues to whether a
company is risk heavy.
Selling stockholders – Does the prospectus mention that the
management and/or private owners of the company are selling a hefty
percentage of their stake? If so, the enterprise’s prospects may
not be all that bright and the IPO proceeds may be destined to make
insiders wealthy rather than fueling the company’s growth.
Valuation clues – Closely check any discussion of the company’s
financial positions, including its revenue, margins and profits, to
estimate whether the stock is fairly valued. Review the financial statements
to see if the company’s key financial ratios are in line with industry
trends. How is the current and long-term cash flow? Is the company debt
heavy? Are there any extraordinary expense or loss items on the income
statements? All of these factors impact the stock price and long-term
value of each share of stock. Investors not familiar with financial
statement analysis are sure to miss these and other "red flags".
Before buying any stock, consider consulting a knowledgeable financial
advisor. Traders and investors should always have the big picture in
mind. What are you trying to accomplish by purchasing an individual
security? Stocks should always be purchased as part of an overall financial
plan. Your investment advisor can help you learn more about a particular
stock, or perhaps point out other, more appropriate investments to help
you reach your financial goals.
Daniel L. Gracy
Daniel is the owner of Gracy and Associates, a Financial Advisory
Branch of American Express Financial Advisors. His offices are located
in Danvers, Massachusetts. Gracy and Associates specializes in providing
personalized financial plans for individuals and small businesses.
Gracy and Associates
Phone: (978) 777-8382
E-Mail: Daniel.X.Gracy@aexp.com
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