Initial public offerings (IPO), the first time that the stock of a private company is sold to the public, got a little crazy in the dotcom mania days of the 1990s. Back then, investors could throw money into just about any IPO and be almost guaranteed killer returns—at least at first. People who had the foresight to get in and out of these companies made investing look easy. Unfortunately, many newly public companies such as VA Linux and theglobe.com experienced huge first-day gains but then ended up disappointing investors in the long run.

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.

Nowadays, there is once again money to be made in IPOs, but the focus has shifted. Rather than trying to capitalize on a stock's initial bounce, investors are more inclined to carefully scrutinize its long-term prospects.

Key Takeaways

  • It is difficult to sift through the riffraff and find the IPOs with the most potential.
  • Learning as much as you can about the company going public is a crucial first step.
  • Try to select an IPO that has a strong underwriter—a major investment firm.
  • Always read the prospectus of the new company.
  • Be skeptical if a broker is pitching an IPO too hard.
  • Waiting until corporate insiders are free to sell their company shares, the end of the "lock-up period," is not a bad strategy.
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IPO Investing Tips

Participating in an IPO

Firstly, 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 partake in an IPO, an investor must register with a brokerage firm. When companies issue IPOs, they notify brokerage firms, who, in turn, notify investors.

The largest U.S. IPO to date remains that of Chinese internet company Alibaba, which in 2014 raised $21.8 billion.

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

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

1. Dig Deep for Objective Research

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 good intel 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 might lead to the discovery that a company's prospects are being overblown and that not acting on the investment opportunity is the best option.

2. Pick a Company With Strong Brokers

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 are more likely to be associated with quality. It’s important to exercise extra 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 a much smaller, relatively unknown underwriter can.

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

3. Always Read the Prospectus

We've mentioned not to put all your faith in a prospectus, but you should never skip perusing it. It may be a dry read, but the prospectus, which can be requested from the broker responsible for bringing the company public, lays out the subject’s risks and opportunities, along with the proposed uses for the money raised by the IPO.

For example, if the money is being deployed to repay loans or buy the equity from founders or private investors, it may be worth giving the IPO a miss. This isn’t an encouraging sign and tells us the company cannot afford to repay its loans without issuing stock. Generally speaking, money that is going toward research, marketing, or expanding into new markets paints a much better picture.

In addition, one of the biggest things to be on the lookout for while reading a prospectus is an overly optimistic future earnings outlook. Over-promising and under-delivering are mistakes often made by those vying for marketplace success, so it’s important to read projected accounting figures carefully.

4. Be Cautious

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 a lack of available information. Consequently, you should always approach them with caution.

That’s particularly the case if your broker recommends an IPO. When this happens, it tends to indicate that most institutions and money managers have graciously passed on the underwriter's attempts to sell the stock to them. 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 a certain offering, there is probably a reason behind the high number of these available shares.

This should also serve as a reminder of another important point: it’s difficult for the average investor to acquire shares in a decent company about to go public. Brokers have a habit of saving their IPO allocations for favored clients, so, unless you are a high roller, chances are you won't be able to get in.

Even if you have a long-term focus, finding a good IPO is difficult, as they exhibit many unique risks that make them different from the average stock.

5. Consider Waiting for the Lock-Up Period to End

The lock-up period is a legally binding contract, lasting three to 24 months, between the underwriters and company insiders that prohibits investors 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 wealth on paper—in 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 along with his personal net worth.

This overvaluation was noted during the lock-up period, though, meaning that even if Cramer had wanted to sell, he was legally forbidden to do so. Only when lock-ups expire, are the previously restricted parties permitted to sell their stock.

In theory, 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.

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.

The Bottom Line

Successful companies regularly go public, yet sifting through the riffraff and finding those with the most potential is no easy task. That isn’t to say that all IPOs should be avoided, though. Some investors who bought stock at the IPO price have been rewarded handsomely by the companies in question.

Just keep in mind that when it comes to dealing with the IPO market, skeptical investors with their fingers on the pulse are likely to see their holdings perform much better than those who are trusting and ill-informed.