Playing IPOs can be a lucrative game – provided you understand the risks.
An IPO’s biggest risk is the lack of trading history. Every stock has a “character” – a pattern of trading based on its price, float, capitalization, ownership and other factors but it is unknown how these factors will play out in a new stock. Understanding IPO dynamics will help you see the risks and how they manifest themselves when making trading decisions.
1) When the market is tough and the IPO market is moribund, underwriters try hard to jump start it by bringing out the best deals at reasonable prices. When the market overheats, everyone rushes in to take advantage of the window of opportunity, so all sorts of junky deals get pushed out the door and the valuations are jacked up, to the detriment of post-IPO price increases.
2) In most IPOs, the proceeds go to the company for growth and expansion. A small number of shares may be sold by existing shareholders – that’s understandable, given the risks they have taken. But in some instances, most of the shares are sold by existing shareholders; the company does not get any of the proceeds. It’s usually a red flag: if the current shareholders are selling, why should you be buying?
3) Some IPOs are brought out by private equity funds. Private equity usually does not create new opportunities – it repackages the old ones by buying once great companies that have run into trouble, turning them around, and reselling them at a profit. Private equity deals usually try to squeeze every penny of profit out of the stock so there is little left for post-IPO investors. Besides, impatient selling by private equity may impede future stock advances.
4) Many investors eager to get in on an IPO put in market buy orders before the stock opens on the first day of trading. When all the orders hit the market at the same time the stock is likely to gap up at the open.
5) An IPO can get too “hot,” meaning that there will be so much buzz about it that it will be priced way above any reasonable valuation, and there won’t be much upside left for retail investors.
6) After a stock IPO’s, you don’t know who owns the float and what their plans are. They may be “flippers” – short-term traders who bought to sell for a quick profit, whose selling can kill an advance. On the other hand, a large percentage of the offering may end up in the hands of long-term institutional investors, which will reduce the number of shares available for trading and put upward pressure on the stock price.