Comparing a direct listing against an IPO will show that the direct route is cheaper. But stock quality is still the most important factor in a buy decision

An initial public offering or IPO, is the first sale of stock by a company as it goes public. Initial public offerings are by far the most common way for a stock to list on the market.

Direct Public Offerings (DPOs) aim to minimize broker involvement and cost. You might also say they make the new-issue process fairer for investors. Here’s a look at the pros and cons of a direct listing vs. IPO.

How Successful Investors Get RICH Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor. How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Slack Technologies is a prominent example of a DPO

Slack Technologies (symbol WORK on Nasdaq) went public through a direct listing on the New York Exchange. In opting for that process, it avoided the traditional and usually costly IPO process.

Slack’s successful DPO could help influence how private companies in the future sell shares to the public. A direct listing not only lets them avoid paying, say, $100 million or more in fees to investment banks, it also lets them avoid diluting the interests of existing shareholders by putting new shares on the market.

Slack went public on June 19, 2019. As mentioned, it opted for a direct listing on the New York Stock Exchange instead of the customary underwriting process. The company’s existing shareholders, large and small, were allowed to sell their shares up to a combined preset limit of 283.4 million shares. Slack, itself, did not raise any funds through the direct listing.

In addition to being a direct offering, Slack’s share sale was unusual in that it’s a “secondary offering”—an open market sale by the company of insiders’ stock, rather than so-called treasury shares, that companies sell to raise money for their own internal purposes.

Whether it’s a direct listing vs. IPO, you still need to avoid poor new issues

In IPOs, stakeholders often sell a portion of their shares to recoup their investment during the first weeks and months the stock begins trading. That’s part of why we advise investors to watch IPOs carefully before investing.

Our general rule on IPO 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.

Another phenomenon that investors should know about is initial public offerings receive an excessive amount of hype from what we call the “broker/media limelight.” This can cause expectations to be raised to often unrealistic heights, and the fall from those heights can be swift.

Understand the downfalls of the broker/media limelight to keep more of your money in your portfolio

We believe it’s crucial to downplay stocks that seem to be near-universally recommended by brokers and are showered with enthusiastic media coverage. In investing, familiarity can breed excessive feelings of comfort, security and performance.

When investor expectations are high, it pays to be skeptical and wary. It’s true that a number of broker/media favourites may go up more-or-less steadily for years at a time.

But when stocks fail to live up to investor expectations, as they inevitably do from time to time, their stock prices can plunge. And when they come down, they take a lot of people by surprise, and they can fall much further than you ever thought possible.

Bonus tip 1: Rather than focusing on a direct listing vs. IPO scenario, look for corporate spinoffs for more potential to profit

In one sense, a spinoff is the opposite 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 because they feel the market will undervalue the stock. 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.

Investors who buy new corporate spinoffs include seekers of undervalued stocks. On the whole, it pays to follow the lead of these value seekers. You should also have the patience to hang on through a period 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 at all, thoroughly research the company to determine what, if any, long term growth prospects it may have.

Bonus tip 2: Use our three-part Successful Investor approach to make better stock selections

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Some analysts believe a direct listing comes with more risk because of the eliminated lock-up period. What are your thoughts on this?

It can be hard to ignore the buzz around a big IPO. What do you do to maintain perspective and make smart investing choices?