IPOs For Beginners
There are approximately 2,800 listings that trade on the New York Stock Exchange (NYSE), and a comparable number that trade down the street on Nasdaq. These companies range from the leviathan (Apple, worth a collective half a trillion dollars), to the inconsequential (each with a market capitalization of less than the price of a car). Every last one of those companies had to start somewhere. They each sprang to trading life as initial public offerings (IPOs), originally going on sale to ravenous investors and speculators looking for quick, if not instant, profits.

SEE: Top IPO Nations

How an IPO Works
IPO is one of the few market acronyms that almost everyone is familiar with. The term conjures up pictures of sudden millionaires watching in glee as their previously inert holdings are translated into actionable money. If you've taken even a cursory look at the business news over the past few months, you're probably aware that Facebook is moments away from its initial public offering. Today, you can't buy Facebook stock because there's no publicly available stock to buy. One morning, however, that will change; the trading floor will open, Facebook's symbol will scroll across the ticker and its stock will be available to whomever wants it - kind of.

Before an IPO, a company is privately owned - usually by its founders and maybe the family members who lent them money to get up and running. In some cases, a few long-time employees might have some equity in the company, assuming it hasn't been around for decades. The founders give the lenders and employees a piece of the action in lieu of cash. Why? Because the founders know that if the company falters, giving away part of the company won't cost them anything. If the company succeeds, and eventually goes public, theoretically everyone should win: a stock that was worth nothing the day before the IPO will now be worth some positive number of dollars.

However, because their shares don't trade on an open market, those private owners' stakes in the company are hard to value. Take an established company like IBM; anyone who owns a share knows exactly what it's worth with a quick look at the financial pages. A privately held company's value is largely a guess, dependent on its income, assets, revenue, growth, etc. While those are certainly much of the same criteria that go into valuing a public company, a soon-to-be-IPOed company doesn't have any feedback in the form of a buyer willing to immediately purchase its shares at a particular price.

Anonymity Vs. Fame
The vast majority of those roughly 5,600-odd NYSE and Nasdaq listed companies have been trading in glorious anonymity from day one. Few people care what Cardinal Health or Trinity Industries do on a regular basis, or even know they exist, and management prefers it that way. (Just ask publicly traded British Petroleum (BP) whether no news is good news.)

When most companies offer shares to the public, initially the news barely registers with anyone outside of the securities industry; however, when a highly publicized Facebook, Yelp or Groupon walks onto the dance floor, lay people take notice. That's because such companies operate on the retail level, or its equivalent. They're ubiquitous. There aren't hundreds of millions of people logging into their Cisco account to post photos multiple times a day, and no one's going to make a Hollywood feature film about the brash young Ivy Leaguers with big dreams who founded American Railcar Industries.

Can You, and Should You, Buy?
So why doesn't every investor, regardless of expertise, buy IPOs the moment they become available? There are several reasons:

The first reason is one based on practicality, as IPOs aren't that easy to buy. Most people don't have brokerage accounts, it takes time and money to open one, and even if you make it that far, placing a "buy newly issued stock X" order is harder than it sounds. The company that's about to go public sells its shares via an underwriter - a giant investment bank tasked with the process of getting those shares into investors' hands. The underwriters give first crack to institutions - i.e., if you're a Morgan Stanley account holder, Morgan Stanley brass is going to keep its allotment of a finite IPO and offer the rest to its favorite (i.e., largest) clients, before deigning to let you on board.

Almost every stock's price falls from its IPO level for reasons that will be clear in a few seconds. When a stock goes public, the company insiders who owned the stock in the first place are legally prohibited from selling it for a fixed period - set by Securities and Exchange Commission (SEC) regulations - of at least three months. Up until that point, the insiders are rich only on paper. The moment they can sell, they usually do - all at once. This, of course, depresses the stock price. It's at that point, with a glut of shares entering the market, that ordinary investors often get their first crack at what is now an IPO well along in its infancy.

The Bottom Line
The late and legendary Benjamin Graham, who was Warren Buffett's investing mentor, decried IPOs as being for neither the faint of heart nor the inexperienced. They're for seasoned investors; the kind who invest for the long haul, aren't swayed by fawning news stories, care more about a stock's fundamentals than its public image, like companies that have something of a definable history, stay objective, have established bankrolls, and aren't in the habit of buying stocks that have downward pressure applied on them out of the gate. If that doesn't describe you - and let's be honest here, it doesn't - do yourself a favor: Like piloting jetliners and removing gallbladders, leave the job of investing in IPOs to the professionals.

SEE: The Biggest IPO Flops




comments powered by Disqus
Trading Center