Understanding the risks and rewards when choosing the best IPOs to invest in
We’ve often pointed out that IPOs (Initial Public Offerings, otherwise known as new stock issues) are generally poor choices for most investors. Their first and biggest drawback is that they come on the market when it’s a good time for the company or its insiders to sell. This is not necessarily a good time, and may be a bad time, for outsiders to buy.
Of course, many investors agree to buy new stock issues because of rumours or hints from a broker or the media that an upcoming new stock issue may turn out to be a “hot new issue.” That’s a rare new stock issue that shoots up soon after coming on the market.
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Brokers reserve the bulk of most hot new issues for their best clients. These may be clients who do a lot of trading (and generate a lot of commission income for their brokers). Or they may be current clients who are in a position to refer new clients to their brokers. Or, they may be clients who bought new issues on their broker’s recommendation, and wound up losing money.
Let the taint and/or excitement wear off before you decide on the best IPOs to invest in
A wide variety of conflicts of interest come into play in the price and timing of an Initial Public Offering. As we’ve said, IPOs come on the market when it’s a good time for the company and/or insiders to sell stock to the public.
This may be because the insiders think their company is on the brink of a great business opportunity. They may want to sell some shares so the company has cash to finance growth in that upcoming opportunity.
Or, the insiders may foresee potential difficulties ahead. They may think they can sell the stock now, then buy it back in the market in the future at lower prices. Of course, they may foresee opportunity ahead, but doubt how well their company can take advantage of it. Either way, it may not be a good time for the public to buy.
Then too, new-issue buyers ultimately pay the costs—legal, accounting, brokerage fees and so on. These costs can burn up 5% to 10% of the price paid by new issue buyers. This is like the extra cost of buying a new car, which can drop in value by 5% or even 10% when you drive it off the dealer’s lot.
That’s why we rarely recommend buying new issues when they first come on the market. However, we don’t write them off permanently. If we like the company, but not enough to overcome its hypothetical “new issue risk,” we keep the company in mind and check in on it from time to time.
After all some new issues sputter when they start trading, but they turn into dynamite investments if you wait a few months or years.
Avoiding IPOs does not necessarily mean you miss out on great opportunities
People in the business will tell you that if you avoid IPOs altogether, you’ll miss out on some great opportunities. Some IPOs do turn into “hot new issues,” and double or triple or more soon after they hit the market. However, IPO underwriters know early on if a new issue is likely to succeed. That’s because they get out and promote new IPOs ahead of time to their biggest and best clients—financial institutions, heavy-trading hedge funds and so on.
Members of this select group get to buy first, and the best opportunities sell out early. The average investor may get to buy a few shares, if any.
When deciding to make any investment, use our three-part Successful Investor approach:
Hold mostly high-quality, dividend-paying stocks.
Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
Downplay or stay out of stocks in the broker/media limelight.
Is there really such a thing as the best IPOs to invest in? What do you think?
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