If the goal of investing is to buy low and sell high, then getting in on an initial public offering — more commonly called an IPO — must be the ticket to riches. Buy a hot new stock at a discount and then sell it for a huge profit just hours or days later, right? Seems like a sure thing.
But for most individual investors, that dream of getting in on the IPO action will never be realized.
That’s not necessarily a bad thing because for every fairy-tale stock that takes off like a skyrocket following an IPO, there are cautionary tales of many more IPOs that post lackluster results. Some even crash and burn.
Still, 2019 promises a potential bonanza to investors looking to cash in on the gold rush mentality expected from IPOs announced by ride sharing giants Uber and Lyft—recently valued at $72 billion and $15 billion respectively.
Added to the excitement is the buoyancy created by the expectation that Airbnb, WeWork and Pinterest have all announced they may offer IPOs in 2019.
Before rushing to invest a pocketful of cash in an IPO, it’s important to know how to buy an IPO. Further, ask a trusted financial advisor questions like:
Is it good to buy IPO stocks? And how long before I can sell IPO stocks to make a profit?
The following tips should give you guidance on how to buy an IPO.
How an IPO is determined
First, understand the process: When a company goes public and issues stock, it wants to raise capital and make shares available to the public. The IPO is underwritten by an investment bank, broker dealer or a group of broker-dealers. They buy the shares from the company and then distribute the shares to investors.
But shares of stock are not always immediately offered to the public for sale. Until the larger institutional players decide they want the IPO to “go public, individuals and smaller investors cannot buy shares of the company.
“The brokers find a home for the largest pieces. If there is a lot of interest, the shares go very easily into the hands of institutional investors,” says Rob Lutts, president and CIO of Cabot Money Management in Salem, Mass.
The goal of offering an IPO in the first place is to raise a certain amount of capital so selling a million shares to an institutional investor is much more efficient than finding 1,000 individuals to purchase shares.
But even big institutions often don’t get as much of the action as they would like because the initial public offering may be quite limited.
“Especially with a smaller IPO, nobody really gets 100 percent of their fill. In fact, no one gets more than 10 percent of their interest in the allocation,” says Kathleen Shelton Smith, principal at Renaissance Capital, a global IPO investment adviser, research and management company.
Is it a good idea to buy IPO Stocks?
Institutions that get to participate in the initial public offering often do a lot of business with the brokers underwriting the deal.
“It’s stacked in favor of large asset managers, but it is a money game and everyone is in it to make a buck and that is where it goes — it goes to the best customers of those brokers,” Lutts says.
The reality is your broker perceives you as poor. Management, employees, friends and families of the company going public may be offered the chance to buy shares at the IPO price in addition to investment banks, hedge funds and institutions. High net worth clients may be rewarded with IPO shares from time to time as well.
If you have an account with the broker bringing the company public and happen to keep most of your vast fortune with that broker, you may be able to beg your way into a hot IPO.
“That still doesn’t mean you’re going to get in. For LinkedIn’s (IPO), for instance, unless you were friends or family, you were probably out of luck,” says Jeremy Carpenter, portfolio analyst with Investor Solutions in Miami.
Lutts agrees, “I manage $500 million and I can’t get the really hot ones.”
How to buy an IPO
Once the stock is trading on the exchange, small-fry investors and big-time professionals have plenty of opportunities to buy shares. In fact, waiting for an opportunity can be a smaller investor’s best strategy when it comes to new public companies.
As soon as the underwriting bank sets the price and it starts trading on either NASDAQ or NYSE, individuals can start buying IPO stock. In either case, you typically have to make your purchase through a registered stockbroker.
An alternative may be investing in one of a handful of mutual funds that invest in IPOs, such as Renaissance Capital’s Global IPO Plus Aftermarket.
“We’re really looking at investing in these companies that are not well-known yet by the market and that have an ability to get us gains very early in the price discovery,” says Renaissance Capital’s Kathleen Shelton Smith.
How long before I can sell IPO stocks?
One of the biggest attractions of buying IPO stock is the enormous potential for profit making—often on day one. When LinkedIn shares were first publicly offered, prices rose 109 percent from $45 to $94.25 on the same day.
In general, it’s likely your stocks are held with your brokerage account and can be sold at any time with a phone call or click of your mouse. You can typically also place a limit order whereby you set the price and number of shares you want to sell.
However, be aware that you probably will owe commissions and fees to your broker. In addition, profits from shares held for less than one year from the date of sale, are taxed just like ordinary income.
Now for the downside potential
Smaller investors still need to weigh the pros and cons before developing a strategy on how to buy an IPO. As the time-honored adage goes, buyer beware because IPO purchases are not without risk, which can be significant at times.
“So far this year, over 57 percent of the IPOs are trading below their IPO price. It may be smart for the individual investors to look at IPOs, but maybe they shouldn’t feel that they’re missing a whole lot,” says Shelton Smith.
Consider that some of the highest flying IPOs of recent times have lost their luster with Wall Street investors. Snapchat, Twitter, Spotify and even Facebook are not trading anywhere near their initial public debuts.
Also, the discount offered at the initial public offering generally is not that great. According to Shelton Smith, the IPO price should be, on average, a 13 percent to 15 percent discount from what might be the regular trading price.
Buyers should also research the business models of the company offering the IPO and be more selective how they make choices because improperly thought out roadmaps and irregular records of profitability should be red flags.
New IPOs often have limited histories and their valuation can be somewhat mysterious. This is particularly true when a company is in a nascent industry, as dot-com companies were in the 1990s and social media companies are today.
To get some insight into how the company works and how the stock is valued, investors can look at the massive registration document required by the Securities and Exchange Commission for all new securities.
Known as Form S-1, or the Registration Statement Under the Securities Exchange Act of 1933, the offering document must contain specific information for investors, including financial information, the business model, risk factors and information about the industry. These documents can be found on the SEC’s website, and they are normally loaded with caveats and disclaimers.
If investors can wade through the document, they can glean enough information about the new company to make a call about the valuation — is it worth buying at the price people are selling?
Knowing how to buy IPO stocks requires a lot of homework, and they can be incredibly risky. Most individual investors should consider very new companies carefully, and experts recommend devoting no more than 2 percent of your portfolio to any one stock.
Ultimately, the way to get rich isn’t with one successful investment, but by growing a diversified portfolio over time. Just ignore the fairy tales.