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 rocket following an IPO, there are cautionary tales of plenty of IPOs that post lackluster results. Some – such as meal delivery service Blue Apron – even crash and burn.
The year 2019 has seen a bonanza of long-awaited IPOs, with big names such as ride-hailing firms Lyft and Uber making their debuts. Social media network Pinterest also hit the market, and office co-location specialist WeWork and home-sharing firm Airbnb are also lining up to debut.
But before rushing to invest a pocketful of cash in an IPO, it’s important to know how to buy an IPO.
The following tips should give you some helpful guidance on how to buy an IPO.
Basics of an IPO: How they work
How do you buy IPO stock? First, understand the process: When a company goes public and issues stock, it wants to raise capital and make shares available to the public to purchase. The IPO is underwritten by an investment bank, broker dealer or a group of broker-dealers. They purchase the shares from the company and then sell (and distribute) the shares at the IPO to investors. Until the IPO happens, the company remains private.
“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 an IPO in the first place is to raise a certain amount of capital for the company to run its business, so selling a million shares to an institutional investor is much more efficient than finding 1,000 individuals to purchase the same amount.
But even big institutions often don’t get as much of the action as they would like, because the initial public offering sells only a limited number of shares.
“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 and investment adviser.
Who gets 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’s a money game and everyone is in it to make a buck and that is where [the stock] goes — it goes to the best customers of those brokers,” Lutts says.
The reality is your broker perceives individual investors as poor. Instead, 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 long before I can sell an IPO stock?
One of the biggest attractions of buying IPO stock is the enormous potential for profit making — often on day one. When shares of LinkedIn 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 a brokerage account and can be sold at nearly any time either online or with a phone call. 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 will probably owe commissions to your broker. In addition, profits from shares held for less than one year from the date of purchase, are taxed as ordinary income, which is often higher than the long-term capital gains rate.
Finding an IPO and getting in
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 the exchange, individuals can start buying IPO stock.
An alternative to buying the stock directly 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 [process],” says Shelton Smith.
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Risks of buying an IPO
Smaller investors still need to weigh the pros and cons before buying an IPO. As the time-honored adage goes, buyer beware. IPO purchases are not without risk, which can be significant at times.
And while the first-day pop of an IPO is legendary, that doesn’t mean that the future works out as merrily. Consider that some of the highest-flying IPOs of recent times have lost their luster with Wall Street investors after an initial honeymoon.
Snap, Twitter, Spotify and even Facebook all fell substantially after their stocks debuted, and of this group, only Facebook has managed to surpass its IPO price on a consistent basis.
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 once the stock is public.
If you’re considering buying an IPO, you’ll need to research and evaluate the company’s business model. You’ll look to assess its future plans and want to see whether the company is consistently profitable or at least has a path to consistent profitability.
Amazingly, many companies come to market without a clear plan to generate sustained profits. That’s the case with the recent IPO of Lyft, which has said it may never make money.
New IPOs often have limited histories and so it can be tough to assess and value them. This is particularly true when a company is in a nascent industry, as dotcom companies were in the 1990s, and social media, ride-sharing and electronic payments 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. This document can be found on the SEC’s website, and it is 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?
Buying IPO stocks requires a lot of homework, and they can be risky.
Even for those who are able to get in on the first-day pop, IPOs may not be a sure bet. So most individual investors should consider new companies carefully, and it’s wise to limit your position size on any individual stock to a few percent of your holdings.
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— This story was initially written by Steve Santiago.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.