Advantages of Investing in IPOs

Fundamental Considerations in IPO Investing

Investing in an IPO, where the investor is committing to holding it over the long term generally, is seen as highly desirable by many investors, and certainly more so than just buying stocks on the secondary market, including the stock being offered by the initial public offering.

Some IPOs are the stuff of legends, and as often the case with legends, the tale tends to be larger than life. There’s a lot to consider when looking to invest in an IPO, and this is far from the shooting fish in a barrel or being allowed to participate in a windfall that some people think this is though.

Advantages of Investing in IPOsWhile there are some real potential pitfalls with IPOs and they are certainly riskier than normal share purchases, there are some real advantages with them as well. We never want to just look at the advantages without fully considering the potential disadvantages though, but in terms of the advantages, there are some pretty clear ones with IPOs and there’s a reason why people get so excited about them, even though this excitement does need to be tempered somewhat.

Investing is far less exciting than trading is, where you’re just looking to buy a stock and hang on to it for several years, and even if the performance jumps for a period of time, there really isn’t that much reason to get that excited if you’re going to sell it 20 years from now. What it is doing now may be interesting and we may want to count our mark to market paper profits and delight in that, but unless we are considering selling now, that’s simply not going to matter much.

If we are investing in the long term though, we do need to need to be aware of what the prospects of our coming out ahead significantly will be, and this relies to a large extent on the fundamentals of the stock. How good the company is along with how good the market is expected to perform over time are things that may be meaningless to the shorter term trader but certainly do matter to long term investors.

People can invest in the shorter term as far as investing goes though, holding for a few years as opposed to a few decades for instance, and for these traders, the market itself and not so much the fundamentals of the company and market will matter more, and perhaps even solely matter. In this time frame, market behavior and expectations will drive the price more than anything, although even an investment of this shorter time frame will run into such things like earnings reports and inflows and outflows in the market overall based upon economic factors, so it’s not that fundamental considerations don’t matter as well here.

IPOs Offer World Class Fundamental Analysis for Free

One of the biggest benefits of investing an an IPO, and one that few investors consider, is that IPOs are backed by the best fundamental and market analysis out there. When IPOs hit the market, investment banks that underwrite these offerings put a tremendous amount of resources into pricing them, which does tend to be beyond what we normally see in the industry.

Often times, the fundamental analysis that we rely upon is too company centered, and this is a pretty big flaw in the way we tend to approach fundamental analysis generally. It’s not that the fundamental analysis that is behind IPOs isn’t without its flaws as well, but it does have the advantage of looking at both the long-term outlook and the near term, as well as taking into account market and economic factors, something that traditional fundamental analysis of stocks doesn’t do that well.

The goal of the analysis prior to the release of an IPO is to see the stock hit the ground running, and there are even rules such as the lock in period where insiders are not allowed to sell their stock that places the IPO with an even greater advantage initially.

The important point to realize here is that the focus on IPOs from the perspective of the underwriters isn’t just exclusively on the long term, it’s actually a lot about the short term as well, which the lock in rule is an example of.

Companies do not have their performance influenced very much by their stock price, and aside from operations such as issuing or buying back stock that companies partake in from time to time, the stock price and the business fundamentals have nothing to do with each other. Companies make money independently of how much people will pay to own the company, although how they do does influence stock prices.

It doesn’t really go the other way though, at least as far as stock prices affecting business performance, but it does affect the equity that owners hold. Considering that a big reason why companies go public is to see their private shareholders cash in, how the stock does in the early phase of its offering is going to matter a lot to those that are behind the IPO and the company.

Building in Value with IPOs

On the other hand, underwriters, the big investment banks that place company stock in the market, also have to consider the needs of those looking to buy the stock, and almost all of this goes to large institutional investors.

This balance that is struck ends up taking care of the needs of both, where underwriters seek to have the stock’s early performance positive so that it can develop momentum, and also will price it in such a way that it promises more long term value than just buying competing stocks on the secondary market.

It is the offering of these relative bargains that contains the real value of the IPO, and the real reason why they tend to be of higher value overall, seeing them underpriced somewhat. This allows them to appreciate more in value over both the short term and the long term, where the company’s stockholders are happy because they can finally cash in some of their positions, and the funds are happy because they are getting a deal.

This of course doesn’t always happen, but these influences are in play generally, and while some IPOs don’t meet expectations and some even do terribly, overall these conditions are present in IPOs and do represent added value typically. Funds of course do not live or die based upon a single position, and can take on the additional risk of some IPOs not doing well pretty comfortably, although this may not be the case for individual investors who may have too much riding on a single play.

There are actually two important components to this initial value being offered, which is the lower pricing itself and its being based to a large degree on long term value. This is where the fundamental analysis comes in, where we can reasonably expect that if the banks have done their homework, and they do try their best, the initial pricing should provide further opportunities for long term as well as short term value.

Many investors use various means to assess a company’s prospects, some of which may be pretty superficial, but you can count on the analysis of investment banks to be superior to one’s own or the analysis you typically see in the media.

Predicting the future prospects of a company is by no means an easy task, as there are a lot of unknown factors involved, but we can come up with some predictions that are at least more likely to come true than not, if we are truly skilled and devoted to doing so.

This type of quality of analysis is usually well beyond what individual investors have access to, but by participating in IPOs, they end up piggybacking on all of the analysis that goes into initial public offerings, along with a pricing model that seeks to understate the benefits that are discovered.

Deciding to Take Advantage of All This

This is a pretty nice position to get in, and the view that IPOs do offer better value overall that a lot of investors have does have some truth in it, although this is the case overall with IPOs and not necessarily will play out with any given IPO.

Only select investors who have good sized accounts and are particularly highly valued by the brokers offering an IPO get a chance to step up to the plate and buy stocks before they hit the market.

Allowing clients to participate in an IPO is certainly considered to be a real perk, and investors do tend to see it that way as well. Sometimes the IPO won’t work out, but if one participates in several of them, chances are that the better odds offered with them will provide an overall return with them that is superior to just trading in secondary stocks.

We can do as good or better with secondary stocks, but this does take skill, and investors generally don’t have much of this and rely on others to provide it for them. With IPOs, these desired skills are essentially built in, and this is a lot like getting a pick from someone who really knows what they are doing, and investment banks that underwrite IPOs certainly do, and have much more on the line with these offerings than individual investors do.

This does not mean that we should just jump at any IPO that comes our way, if they ever do, or especially to look to jump on them when they hit the market. It’s not even that we should look to be selective here, as most investors wouldn’t have much of an idea of even how to do that, it is more that we need to consider the additional risk that an IPO has and not take on more risk than we are comfortable with.

If we can handle the risk though, the risk reward ratio of IPOs, where we do get in on the ground floor prior to the market bidding these stocks up in an atmosphere that is biased toward seeing just that, does tend to be superior to what people normally do with their investments, buying on a lark or on superficial analysis or even just hope.

There’s a lot behind IPOs and generally far more than most investors can hope to take advantage of otherwise, so they are certainly at least worth considering should the opportunity to participate in one arise.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.