Stock Market Advice – Initial Public Offering

31
December

All equities (stocks) start out somewhere, before they appear in stock exchanges such as the New York Stock Exchange (NYSE). The NYSE and all the other stock exchanges in the world are called “exchanges” because shares of stock are exchanged (for money) between investors. Shares purchased by an investor are made available by being sold by another investor, whether that investor is an individual or a manager for an investment company. This is why the stock exchanges are sometimes referred to as the “after-market.”

The “before” market (not a real term) is the realm of the Initial Public Offering (IPO). An IPO starts when a company that is privately owned decides to pursue growth by raising capital (money) by selling shares of stock to the public. The IPO is offered by a stock brokerage, often one that specializes in launching IPO’s. The broker or brokers that are issuing an IPO are termed “underwriters”.

Their functions include getting investors lined up and committed to purchasing the new stock. Sometimes the price and even quantity of shares of the new stock are not precisely known until the demand by potential buyers can be estimated.

Checking the past record of the brokerage in issuing new stocks is one of the first steps to deciding whether you want to risk investing in one of their IPO’s. Past performance is a pretty reliable indicator of whether the brokerage is competent in selecting companies that can become forces in the market. An internet search can provide some information on underwriters that you may be looking at.

In order to clearly see the big picture, it makes sense to see what happened to the stock prices after issuance by the underwriter. One usual pattern of a newly issued stock is that it rises substantially, immediately. This often results from the fact that not everyone who learned of the upcoming IPO could get in on it. So they buy the stock as soon as it comes out, and the collective demand pushes up the price.

Brokers/underwriters really like this effect, of course, since the individuals at the brokerage can sell most of their own shares for instant profits, sometimes 50% or so. Laws then permit the underwriters to “support” the aftermarket price for awhile, and by several means. Some “less legal” means are sometimes employed by brokers who are not as honest. One tactic is pushing resale of the recently-issued shares onto new investors, and subtly letting them know they must buy some of these stocks before they “get in on” new IPO’s.

This practice is not as rampant in the current environment as it used to be, simply because there is too much fear in the investment world. Go-go marketing of new companies’ stocks just won’t happen during economic recession. Issuing of new IPO’s can be compared to new starts in housing construction – the market isn’t quite dead, but it’s maybe on life support.

IPO shares can be expensive, but most are generally low in price. Buying into IPO’s in this case is a lot like buying into penny stocks – high risks balanced against potentially high profits. Speculative investments like these are not recommended for college funds or retirement savings, for example. Most of the funds available for investment should be put into something reliable, leaving a small piece for speculative “fun” investments.

If you think you want to try IPO investing, there are a few things to look for in addition to the underwriter’s past performance. One word of advice is very simple. Look for a company that is positioning itself in an industry that has growth potential, and that has gotten off to a good start as a private company prior to the IPO. Ask for a “prospectus” and read it several times, comparing it to other like documents. (Brokers should be glad to provide prospectuses.)

Another word of advice: check on a thing called “dilution.” A company that goes public almost always has some corporate officers who already have shares in the company before the public can buy the IPO. Often, these officers have their shares lined up for a very small fraction of the price that the public pays. Since this is a standard practice, dilution has to be regarded in a relative way, i.e. compare the dilution of shares in companies that have already gone public with the one(s) you are considering.

If everything seems okay, and you have agreed to buy a certain number of shares – an affordable number to you – and the broker calls and tells you it would be smart to double your buy, back out. That advice might seem contrary, but that call from the broker means that they have not found enough buyers to complete the IPO. So if you and some others get talked into buying more and enable the IPO to come to fruition, no one will be waiting to buy it when it comes out (in the “after-market”). So the price will probably sink.

That’s one of a number of reasons to tread carefully in the IPO world.

This post was written by

jason – who has written posts on Budget Clowns.
Father of three and married to a lovely women. Always looking for ways to save money, and invest it properly for my children's future.

Email  • Google + • Twitter

Comments are closed.