Wednesday, July 20, 2011

Interested in an IPO?

Nothing is more exciting, interesting, nor mysterious than the IPO (at least in the investing world). Everyone and their brother wants to get shares of this "next big thing". Is it worth it? Can you get shares during the IPO? If you get shares should you hold on to them for an extended period of time (30 days, 90 days, 2 years)? Why are these IPOs so sought after by new and seasoned investors alike? This seems like a good start, but if anyone has any other questions or comments feel free to comment on the bottom or hit twitter (@SellStraddles).

Why are IPO's so sought after by new and seasoned investors alike? Have you ever been sitting on the couch watching t.v. when a commercial for the newest best thing comes on. For argument's sake lets say that you see a commercial for the IPAD 2 while you are sitting watching t.v. holding your original IPAD. Even though you have an IPAD that has very similar functionality you desire the new IPAD 2 because it is the "next best thing". Hype breeds more hype and there is no bigger hype (in the stock market) than an IPO.

Can you get shares during the IPO? Those of you that have read my other posts (shame on you if you haven't) are aware that I did work in the finance industry for approximately 2 years before taking some time off now to finish my MBA. One of the great injustices that I came across while working at a big investment firm was the way IPOs and secondary offerings were handled. For those of you who are not aware how the process works, you can only get shares at the IPO price if you broker/financial advisor works for a financial institution that has taken part in the underwriting. This means that if you do not use a big brokerage house that does underwriting (Wells Fargo Advisors, Merill Lynch, Goldman Sachs, etc.) you do not have access to the shares during the IPO. Now let's say that you do have a brokerage account at one of these major investment firms you are still not guaranteed to get shares in the IPO that you desire. Investment firms hand out the shares that they are allotted in the IPO to their best brokers/advisors who in turn sell these shares to their best clients.

If you get shares should you hold on to them for an extended period of time? If you get involved in a good situation you should hold onto it as long as possible right? Not exactly. If you look at two companies that had their IPO today they are excellent examples. Skullcandy the maker of headphones, apparel, accessories priced their IPO at $20.00 per shares.  When the market opened skullcandy was trading at $23.11 per share, (a nice profit for those lucky enough to be part of the IPO), but by the end of the day the stock was trading exactly where it started at $20.00 per share. Zillow, a company that helps people estimate the value of their home, also had their IPO at a list price of $20. This company ballooned at the open of trading to $57.00 per share. By the end of trading for today the stock was trading at $35.77. This is a hefty profit for one trading day, but both of the IPOs illustrate the same point. You don't make money using a buy and hold strategy for IPOs. Hype is followed by an inevitable exhaustion of the hype, and when hype leaves it tends to leave all at once taking the share price with it. If you are lucky enough to get involved in an IPO it is generally better to sell the shares the morning of the IPO, let the share price settle down, then buy the shares back at a lower price if you believe that the company has a bright future ahead of it. Never buy shares of an IPO the day it is listed if you are not buying it at the actual list price.

End note: It amazes me that this process of dealing out IPO shares can continue to go on the way it does. Supposedly the market is fair for small and large investors alike; whether you own one share of disney or manage an $8 billion hedge fund you are supposed to have equal access and execution for all investment vehicles. (There is a joke in there somewhere) I guess we can only hope for changes in favor of the individual investor at some point in the future.

1 comment:

  1. IPO's are particularly tricky to invest in. There's a lot going on before the company looking to issue stock taps the equity market. There's all sorts of things to take into account such as the management, perhaps if the company had been public before and was taken private by a private equity firm. With all the hype that goes on for IPO's there's often oversubscription involved which could provide clout for what the value of the stock really is. I'll get back to this in just a minute.

    There's plenty of ratios to look at for a stock and models to take into account such as the Dividend Discount Model (DDM). In simplest form, I like to look at the company's financial statements and assess revenue, expenses and profit. They are all distinctly important, but remember the calculation for Basic EPS is "Net income - pref. dividends / weighted shares outstanding". With that being said, I think it's important to look at revenue stream and see if they support the particular stock prices being offered/traded at.

    Retail investors provide too much excitement for some stocks because as you mentioned, they're easy to understand and grasp their attention. With that being said, money mangers, such as hedge funds, look for this sort of hype/trading volume and use their savvy financial models to provide an accurate valuation. By realizing this upward pressure on the stock with unsustainable revenue/income, the money managers often then look to short these stocks citing a price target below where it's trading at.

    Those are some of my thoughts on why retail investors should be careful about investing in IPOs.

    -Scott Roth