How to Invest in Initial Public Offerings - dummies

How to Invest in Initial Public Offerings

By Matt Krantz

Individual investors are very interested in initial public offerings, or IPOs. In an IPO, companies sell pieces of themselves to public investors. Shares are first snapped up by large institutions and high-net-worth individuals at the offering price, which is the price a company’s investment bank guesses the shares will sell at.

This initial sale of stock is the only time the company itself makes money from the IPO. Those initial investors that bought IPO shares at the offering price, though, are free to do whatever they choose with their shares, including selling them to you. Large investors can sell their shares on the stock market, which is when most regular investors can buy them.

When you buy IPO shares after they begin trading, it’s called buying shares in the aftermarket.

IPOs are infamously risky, and studies have shown that regular investors who try to buy them are usually disappointed. Facebook, the No. 1 social networking company, became a classic example of a disappointing IPO in 2012. Investors scurried to buy shares at the offering price of $38 a share.

Many investors who got the shares at the offering thought they won the lottery. But just months after the IPO, shares of the company had lost roughly half their value.

It’s still possible, though, to make money from IPOs. Even if you bought all 198 of 2006’s IPOs at the price they closed on their first day of trading, your return would have been 13 percent.

The table shows you how many IPOs there have been over the past five years, what the average returns for the lucky investors who bought at the offering price have been, and also the average returns posted by regular investors who bought shares in the aftermarket.

IPOs Can Be Profitable, or Not
2007 2008 2009 2010 2011
Number of IPOs 214 31 63 154 125
Return for investors who bought at the offering price and held
shares all year
13% –27% 16% 25% –10%
Return for regular investors who bought at the first-day close
price and held shares all year
13% 3% 7.7% 14.5% –17.5%
Return of broad stock market (Standard & Poor’s
5.5% –37.0% 26.5% 15.1% 2.1%

Sources: IPO data from Renaissance Capital; S&P 500 data (including dividends) from Standard & Poor’s

IPOs continue to struggle to recover from the slowdown following the dot-com crash of 2000 and financial crisis of 2007 and 2008. During 2011, U.S. companies raised $36 billion from 125 IPOs, well below IPO proceeds in the recent past, says Renaissance Capital. During 2007, for instance, companies raised $49 billion from 214 IPOs.

You have four main ways to invest in IPOs:

  • Through actively managed mutual funds: Investing in IPOs through an actively managed mutual fund provides several advantages. Most importantly, you’ll be invested in a variety of IPOs, reducing your exposure to losses if any one newly public company runs into trouble. These funds also have analysts who are trained at studying IPOs, which hopefully means they’ll be able to sidestep the bad or especially risky IPOs.

  • Through index mutual funds: If you want to own a basket of IPOs but don’t want a manager picking which ones, you can consider the First Trust IPOX-100 exchange-traded fund. The ETF tracks the IPOX-100 index, which tracks the 100 largest U.S. IPOs for their first 1,000 days.

  • Through a brokerage: If you’re not a Rockefeller or Hilton, don’t expect to buy an IPO at the offering price. Most IPOs are handled by the investment banking arms of full-service brokerage firms. These firms are then given the right to offer shares of IPOs to their biggest brokerage clients or clients they make the most money from.

    From time to time, online brokers might get their hands on IPOs and offer them to you. But these are rarely the IPOs you want to buy, because if they were that attractive, the full-service brokers would keep them for themselves and their clients. Facebook investors, for instance, who got shares quickly found out why the large investors didn’t want them.

    The SEC explains why it’s nearly impossible for individual investors to buy IPOs at the offering price. Fidelity is one online brokerage trying to cut deals to bring IPOs to its customers, but only time will tell whether these IPOs turn out to be good deals.

    The tight grip that full-service brokers keep on IPOs means that if you want to invest in an IPO through an online broker, you need to buy it when it begins to trade. And you run the risk of paying an inflated price and losing money as a result.

  • Directly from the company: Periodically, a company will try to break Wall Street’s stranglehold on its IPO by allowing individual investors to buy shares at the IPO price. One way to do this, used by Google when it went public, is a dutch auction.

    In a dutch auction, any investor is permitted to enter a bid for the shares before he or she begins trading. The bids are then analyzed, a price is set, and investors who place adequate bids can buy the shares.

Another way you can sometimes get access to IPOs is when companies offer shares to their customers. These deals are often called direct public offerings, or DPOs. Boston Beer, brewer of Sam Adams, allowed customers to buy 25 percent of its 1995 IPO at the offering price. And Internet phone company Vonage offered customers 13.5 percent of its IPO shares. Drew Field/Direct Public Offerings offers more details on these types of offerings.