investing

The IPO: for the wary, studious investor

Highlights
  • To weigh an IPO, begin with the registration statement filed with the SEC.
  • After an IPO is filed, if its price is reduced, it could be a red flag.
  • The best way to invest in an IPO is to buy before the company goes public.

This is the worst market for initial public offerings, or IPOs, since the early 1970s, yet IPO specialists say that investors looking to add some growth prospects to their portfolios shouldn't ignore these opportunities.

Even in a poor economic climate, initial public offerings can play a role in an investing lineup as long as you understand the risks and are willing to check the fine print.

"Rule No. 1 is: Do your research," says Linda Killian, co-founder and portfolio manager at Renaissance Capital, a Greenwich, Conn., firm that provides independent IPO research and investment management services to institutional clients. "Don't just rely on a broker who says this is a good deal."

For average individual investors who can't afford the detailed research from IPO advisory firms, the homework assignment starts with analyzing a prospective IPO when a company files an S-1 registration statement with the Securities and Exchange Commission.

Investors must study the company, its products or services and other players in the market. "Investing in an IPO requires more information than investing in IBM," says Killian, who has a second rule of IPO investing. "Don't get overly excited. Beware of the hype."

IPO players
  • Underwriters: An intermediary between an issuer of a security and the investing public, usually an investment bank.
  • Investors: An individual who purchases assets, in this case stock, with the objective of gaining a financial return.
  • Institutional investors: Large organizations such as banks, finance companies, insurance firms, labor unions, mutual or pension funds or endowments that trade securities, utilizing their own assets.

Uncertain environment

There hasn't been much hype recently because there hasn't been much of an IPO market.

From January through July, more U.S. IPOs had been withdrawn or postponed (38) than had come to market (16), according to data compiled by Renaissance Capital.

Killian says this year's meager IPO output plus the paltry 43 IPOs from last year represent a nadir that hasn't been achieved since the early 1970s when the economy was battered by the Vietnam War, stagflation and high fuel prices.

There was a flickering of excitement when six IPOs came to market in June -- the biggest monthly turnout since May 2008. But, Bill Buhr, an analyst who tracks IPOs for the Chicago-based financial research firm Morningstar Inc. isn't ready to proclaim a recovery.

"We're not ready to say this is a turning point," Buhr says. "But people are dipping a toe in the market."

It's still a little toe. Buhr points out that as recently as 2007, IPOs were often hitting the market at the rate of 20 or more per month. He wonders if "the new normal" might be only a handful of IPOs each month for the near future. Only three IPOs started trading in July while five came to market through Aug. 18.

Is the price right?

Given the recession and still-tight credit markets, the question remains whether companies can convince enough investors to support public offerings. "Pricing is half art and half science," says Buhr. "They need to hit the sweet spot that matches demand without taking money off the table."

Aggressive pricing can dissuade investors, force underwriters to cut IPO pricing and even provoke them to postpone or withdraw an offer.

Although a robust IPO market suggests a stronger economy, a modest IPO market isn't such a bad thing for investors, Buhr says. With less money available and institutional investors more cautious, there's a better chance that the IPO will be attractive to investors and its shares will perform better, if it has a proven business model and some history of sales.

"The days of companies with no products or very little revenue are gone for now," says Buhr.

The most likely IPOs in the current climate will be companies "somewhat resilient to economic uncertainty," he says.

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One example that Buhr cites is Mead Johnson Nutrition Co. in Glenview, Ill., which was spun off from drug giant Bristol-Myers Squibb Co. in New York. As part of Bristol-Myers Squibb, Mead Johnson, which makes baby formula, posted $2.9 billion in sales last year.

Buhr says Bridgepoint Education Inc. in San Diego, which offers postsecondary education services, is a smaller IPO that should be able to cope with the ravages of the recession. By early August, Mead Johnson and Bridgepoint were trading well above their offering prices.

Do's, don'ts and bewares

The still-uncertain IPO market affords the average investor time to take stock of criteria that is crucial to any investment as well as information specific to public offerings.

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