IPO investing issues typically come to market when it’s a good time for the company or its insiders to sell. That’s often a bad time for you to buy.
Investing guidelines and rules of thumb can help you make better investment decisions. But to profit most from any one guidelines, it helps is you understand why it works. That way, you can determine if the rule makes sense in a particular situation.
For example, our rule on IPO investing (Initial Public Offering investing) or new stock issues is simple. We generally stay out of them. That’s because new stock issues typically come to market when it’s a good time for the company or its insiders to sell. That may not be a good time for you to buy. In fact, it’s often a bad time for you to buy, judging by academic studies of IPO investing performance.
They outperform comparable stocks for years
“We can say without reservation that, in investing, spinoffs are the closest thing you can find to a sure thing. It all comes down to the incentives when companies spin off a subsidiary or division and hand out shares to their shareholders. Study after study has shown that after an initial adjustment period of a few months, spinoffs tend to outperform groups of comparable stocks for several years….” Pat McKeough shows how spinoffs and other “special situations” can create windfalls for informed investors.
In addition, brokers reserve their best new issues for their biggest and most co-operative clients—those who do a lot of trading, or who buy every new issue the broker offers them. If you rarely buy new issues, you will rarely if ever be able to buy a significant portion of the best new issues. Brokers know how attractive IPO investing is to clients. With all the hype, investors are eager to buy these particular types of investments. Brokers make greater efforts to cash in on that demand by bringing more of the investment to market. That means the average quality of new issues in popular market areas tends to go down while prices get bid up, sometimes to ridiculous heights. There are exceptions, of course. But this combination of rising prices and falling investment quality leads to bad deals for investors.
Even with attractive new issues, it’s best to stay out of them. If a new issue has genuine long-term investment appeal, it will be an attractive buy for months or years after it reaches the market. A good practice for investors interested in IPO investing is to set up a watchlist of new IPOs they are interested in at the time. After six months to a year, check back to see how these IPOs performed. You may be surprised at what you find. This would be the time to re-evaluate the stock to see if it has a place in your portfolio.
In the past, however, we have made money by making an exception to our IPO investing rules. IPOs are more attractive and often easier to obtain when they are part of a privatization effort—when a government sells a government-owned enterprise to investors.
In privatizations, governments often price the new issue at an attractive level that almost ensures that buyers will make money. That’s because governments are less concerned than a private seller would be about getting a good price in a privatization. Instead, they are more concerned about maintaining the goodwill of buyers, for political reasons. Rather than try to get the best price, they may sell a privatization at a good price to a wide range of individual buyers, to win goodwill and votes in the next election. That leads to two opposing IPO investing rules—we generally avoid new issues, but new issues of companies being privatized can be a good deal.
Investors who like IPO investing should try investing in corporate spin-offs
In one sense, a spinoff is the antithesis of IPO investing. Companies sell new issues to the public when they feel it’s a good time to sell. They do spinoffs when they feel it isn’t a good time to sell, often resulting in undervalued stocks. That probably means it’s a good time to buy.
When a spinoff begins trading, it stands to reason that investors will put a low price on it. After all, the spinoff hits the market with a large number of neutral, if not reluctant, stockholders who have limited expectations for it, and who are willing to sell when they get around to it. Initially there is little, if any, brokerage research available on the company.
The only investors who might be willing to buy a new corporate spinoff are seekers of undervalued stocks who have taken the trouble to read the voluminous material that companies hand out as part of the spinoff process. But on the whole, it pays to follow the lead of these value seekers. You should have the patience to hang on through months of sluggish trading, while reluctant spinoff holders exercise their urge to sell.
IPO investing is not for risk averse investors. If you must dabble in IPO investing, thoroughly research the company to determine what, if any, long term growth prospects it may have.
Have you dabbled in IPO investing? What is your IPO investing track record like? Have your purchased a government-owned enterprise that went public? Share your experience with us in the comments.
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