What’s an IPO? Here’s what you need to know, as well as reasons why investing in an IPO may not be the best decision for your portfolio.

What’s an IPO? An initial public offering (IPO) refers to the process of offering shares of a private company to the public for the first time as a new stock issuance. An IPO lets a company raise equity capital from public investors.

Notably, many of last year’s new stock issues (IPOs) have dropped by 50% or more. Some investors wonder if that’s a sign of a bargain. That’s conceivable. Some broken-down IPOs may turn out to be long-term success stories.

However, a deep drop in price is rarely a reliable indicator of value. In fact, it may mark the start of a much deeper slump.

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Rather than judge an IPO by how far it has dropped since issue, it’s more illuminating to see how long it stays in business. One handy rule is to hold off on thinking about buying at least until we are coming out of the next recession.

If a plunging IPO manages to survive that long and begins to show signs of financial health as the economy recovers, it may be worth a closer look. Just don’t give it any points for how far it plunged. Instead, look for more conventional signs of success such as positive cash flow plus rising sales, if not earnings.

Remember this time-proven rule from our TSI approach to investing: IPOs (Initial Public Offerings or new stock issues) come to market when it’s a good time for the company or insiders to sell. That’s not necessarily a good time for you to buy. In fact, it may be a bad time.

What’s an IPO? An investment worth watching before buying

Initial public offerings often have a turbulent start on the stock market. Stakeholders often sell a portion of their shares to recoup their investment during the first weeks and months the stock begins trading. We advise investors to watch IPOs carefully before investing.

Insiders decide when to bring a new IPO to market. They mostly do so only when it’s a good time for the company or its insiders to sell stock to the public. That means IPOs tend to come to market when the company or its industry is enjoying what may be a temporary improvement in its business or profit. If the improvement is only temporary, this generally isn’t a good time for you to buy.

What’s an IPO in relation to a spinoff?

A spinoff investment is a better option than a new issue.

One key reason why we generally stay out of new issues is that they tend to be riskier than investors realize. New issues tend to be risky due to what you might call “the selection process.” You can only invest in new issues that come to market.

In one sense, a spinoff is the antithesis of a new issue. 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, and that probably means it’s a good time to buy.

What’s an IPO? An investment that often does poorly over time

Long-term studies show that, on average, IPOs tend to do worse than comparable stocks over a variety of time periods.

Professor Jay R. Ritter of the University of Florida recently updated his long-time study of more than 7,000 IPOs that came on the market in the U.S. from 1980 through 2013. He studied returns on the IPOs for the first five years after issue, in two ways.

The average yearly return over five years on the IPOs was 3.1% below the return on existing stocks with the same market capitalization (or “market cap,” the value of all stock each company had outstanding). When Professor Ritter matched the IPOs with existing stocks that had comparable ratios of book value to market value, the IPO’s performance shortfall shrank to 2.0%.

Both comparisons in the study show that IPOs actually beat existing shares in the first six months of trading. That’s when “hot IPOs” (new IPOs that shoot up in price the moment they come on the market) have their biggest impact and bring up the average new issue performance. However, hot IPOs are generally unavailable to the average investor.

There are exceptions to our IPO rule

Here’s one key exception to our warning on IPOS: IPOs are more attractive and often easier to obtain when they are part of a privatization effort—when a government sells a government-owned enterprise to investors.

In privatizations, governments often price an IPO at an attractive level that almost ensures that buyers will make money. That’s because governments are less concerned than a private seller would be about getting a good price in a privatization. Instead, they are more concerned about maintaining the goodwill of buyers, for political reasons. Rather than try to get the best price, they may sell a privatization at a good price to a wide range of individual buyers, to win goodwill and votes in the next election.

Use our three-part Successful Investor approach for all of your investments

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.

Many IPOs are grossly overvalued. Why do you think people choose to invest in them?

Have you had success investing in IPOs?