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From January through July, more U.S. IPOs had been withdrawn or postponed (38) than had come to market (16), according to data compiled by Renaissance Capital.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

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.

Buhr offers one red flag. When an underwriter reduces his client company’s initial offer price range, it could point to reluctance by institutional investors to buy in that range. If the underwriter drops the price more than once, “that would indicate there isn’t much interest,” he says.

An underwriter can offset a drop in his client’s suggested IPO price by offering more shares. But if the underwriter drops the price and the numbers of shares, “you probably want to steer clear,” Buhr says.

IPO expert Scott Sweet looks for several positive factors in any company seeking to go public. It should have rising revenue and very low debt plus rising profits, or it should be moving from a loss to a profit.

“If these criteria are met, these companies will be getting good looks from institutional and retail investors,” says Sweet, senior managing partner and principal researcher at IPO Boutique in Lutz, Fla.

Sweet, whose firm provides IPO research, says important homework assignments for investors include checking how the company stacks up against competitors and whether it serves a niche. Also, check the growth rate and the risk factors, he says.

Here’s another warning to average investors: Don’t buy an IPO on its opening day. “The chances are extremely high that the hedge funds and institutions are selling when you’re buying,” Sweet says.

Getting in early

The best — but most difficult — way to invest in an IPO is to purchase shares before the company goes public. “It’s hard for a smaller investor to get in early” because most of the shares are sold to institutions, says Buhr.

If you want to invest early, you’ll likely need an active, large account with an underwriting firm to have a chance, says Killian.

“The key to playing the IPO game is to have an account with one of the underwriters,” says Sweet. “If Goldman Sachs is doing a deal and you have an account with Merrill, you get zero.”

Some firms, including Sweet’s, will help clients improve their odds by connecting them with brokers who deal with the underwriters selling shares in the IPO.

For example, Boston-based Fidelity Investments is giving brokerage clients a better shot at IPO investing through a deal with Kohlberg Kravis Roberts & Co., the giant New York-based asset management company.

Fidelity’s retail clients can participate in IPOs in the U.S. for which KKR is an underwriter. To participate, a Fidelity client must have $100,000 in a Fidelity brokerage account and must have placed 36 trades — in stocks, bond or options — over a rolling 12-month period, says Fidelity spokesman Steve Austin. This opportunity is extended to clients of registered financial advisory firms and broker-dealer firms connected to Fidelity.

Fidelity recently signed a similar agreement with Deutsche Bank Securities in New York, but you will need $500,000 in a Fidelity brokerage account to participate, says Fidelity spokesman Michael Shamrell. The trading-frequency guidelines for KKR also apply to Deutsche Bank.

Seeking diversity

If you don’t want to take a chance on a single IPO, lack access to an IPO underwriter or don’t have an account with Fidelity, you can try a mutual fund or an exchange-traded fund that specializes in IPO companies.

Although these funds offer diversity of investing in many IPOs, investors still must do their standard research, reading the prospectus to make sure they have the tolerance for risk, volatility and expenses.

Renaissance Capital offers the IPO Plus Aftermarket Fund, an actively managed mutual fund (trading symbol: IPOSX). The fund lost 32.77 percent for the 12 months ending Dec. 31, 2008, but still outperformed the Standard & Poor’s 500 and Nasdaq indexes, according to the prospectus.

Another alternative is the First Trust US IPO Index Fund, an exchange-traded fund from First Trust Portfolios (trading symbol: FPX). This fund invests at least 90 percent of its assets in an index of 100 initial public offerings called the IPOX-100 U.S. Index.

For the year ending Dec. 31, 2008, the prospectus says the fund’s loss of 44.08 percent after taxes on distributions was worse than the Russell 3000 Index. The fund also lagged the S&P 500 and Nasdaq indexes.

Planning for the future

IPOs can certainly improve your portfolio, assuming you are smart enough — or moved fast enough — to score on a up-and-coming winner like an Apple, Microsoft or Google. On the downside, IPO turkeys are too numerous to count.

“Underwriters and companies are wading in slowly because the IPO market is still in that uncertainty stage,” says Buhr. “Investors should be wary, too.”