What Makes IPOs Different

Differences in Perceptions of Fundamentals with IPOs

One of the distinguishing features of an IPO is that its lack of prior history in the stock market will not constrain its price like we see with mature stocks. This phenomenon exerts its effects from both a technical and fundamental standpoint, and in a nutshell, brings to light the fact that with an IPO, no one is really sure what it is worth in the market.

What Makes IPOs DifferentWhile IPOs do have historical fundamental data, what is missing is how the public will view these fundamentals, and all fundamental data that matters to stocks are forward looking. So, this is to a large degree a matter of belief, of predicting, and IPOs lack a history of this,

It is a mistake to view the value of a stock purely fundamentally, because it isn’t really the fundamentals that drive the stock. At best, to the degree that people trading in a stock will do so purely based upon fundamentals, it is the perception of how these fundamentals will change over time that will drive the market.

A stock may be delivering a certain amount of earnings now, and present earnings will always be fully priced into the market, as this is well known to market participants. People buy stock to be held for various periods of time though, so the fundamentals in question will always be future ones, what sort of earnings that the company may attain at a point in time in the future for instance.

This of course involves forecasting, which can be pretty murky and involve a divergence of opinion, especially with companies whose businesses with higher potential for growth. This is why companies with more growth potential tend to trade at higher price to earnings ratios, people are not buying the stock so much on current earnings but on potential future ones.

The way that this potential is going to be perceived by the market is therefore a matter of some degree of subjectivity we could say, and therefore, with an IPO, especially with its relative lack of history of scrutiny, it becomes more difficult to predict how the market will perceive this future potential, in comparison to a mature stock where we already have a history of that under current conditions.

When the outlook for a stock changes, the stock will be subject to this period of re-evaluation, which usually results in greater volatility as we see how the market will ultimately digest this new information. With IPOs, this is the scenario the stock finds itself in at issue and in the early stages of its being available for trading, as the market settles in to discover the generally accepted long term valuation of the stock.

This longer term valuation is itself subject to frequent change though, and the stock may continue to climb for many years, for instance with what we saw with Microsoft. When we look at a monthly chart of MSFT, we see what looks like a constant rise in price over a period lasting almost 20 years, before things finally settled in to a significant consolidation followed by a decade of essentially sideways movement.

So, even though it may seem that the market has priced in an IPO’s longer term value after a certain run up, this process may not even be completed then and it may take a number of years for this to fully manifest. With IPOs though, the process is only beginning of course when the stock is issued and for those who seek to speculate on expanding fundamental outlooks, IPOs often provide ample opportunity to do so.

Differences in Technical Behavior of IPOs

Stocks become driven to a great degree by momentum, and the study and measure of changes in this momentum is the province of technical analysis of financial markets. People are influenced by the price performance of a stock as well as other financial instruments, and will buy or sell based upon performance alone often times, and this is certainly true, and often more so, with IPOs.

The main appeal of IPOs is that they are viewed as having more potential to respond to momentum, and momentum is exactly what drives up prices of IPOs once they hit the secondary market.

This momentum actually exists prior to an IPO hitting the stock market, as a sort of momentum is created during the placement of the IPO in the primary market as well, which we could call the excitement that the IPO has generated.

This excitement has of course to do with the anticipation of the momentum that the IPO may deliver once it hits the public market, and this anticipation surely drives the issue price as well as the price once the stock starts trading. People will pay more for the stock given that they expect it to rise once it hits the street.

Given that the primary reason why people buy stocks is in expectation of a price increase, when we see this expected price increase manifest, this in itself will create more momentum. People have said it will go up, they later look and see that this is coming true, and will buy merely on the expectation that this momentum will continue for a sufficiently long period to profit.

Momentum is therefore to a degree self-fulfilling, at least to the point where the selling pressure increases enough to offset the buying pressure, or to overcome it, where we may then see momentum surface in the other direction.

Some may think that a stock merely moving up in price should not be sufficient reason to buy it, and this may be true to some extent if one’s time horizon is long, but not everyone’s is and many people are more than happy to ride up a wave of momentum and seek to exit the trade once it wanes.

The waves of IPOs can be pretty significant as well as more easily distinguishable, and those who seek to ride these waves certainly contribute to both the length of time that they will rise and their magnitude.

The Lack of Price History of IPOs

When a stock hits an all-time high, there are no technical limitations on it, no areas of resistance in other words, no areas where traders may become concerned that it may not surpass. Stocks in all time high territories may rise up considerably over a period of time, and many traders and investors seek out these conditions and view them as higher potential opportunities.

There is always a concern of profit taking though, where people who have bought the stock at a lower price will choose to close their positions and book their profits, perhaps in anticipation of others doing the same and the price dropping as a result. There is always an ebb and flow in prices and there always can be moves of even a small magnitude that may be identified as the possible beginnings of a bigger sell-off.

Even though a stock may be trading at an all-time high, there will always be some sort of history involved, looking at how a stock traded at an all-time high previously, or looking at how the market in general is behaving at this current point in time.

With IPOs, there is no prior history at all to constrain it, and given that an IPO is so distinct from mature stocks, its correlation with the broader stock market tends to be less as well.

To add to this, the selling pressure with an IPO, in the initial period at least, is artificially constrained, as insiders are not allowed to sell their shares for a given period of time, usually the first three to six months.

So, we’ve now constructed not a free market initially, but one initially biased toward the long side. Large institutions who bought the IPO initially may also purchase more after the release of the stock, which can drive its price up even further.

So, not only is there no history involved here, IPOs are set up so that they will make even more history than would normally occur under market conditions. Together, these elements better assure a significant price appreciation of IPOs during the early stages, and this is in fact what we see generally with them.

Eventually though, we will tend to see profit taking happen, from both insiders and shorter term traders who have been along for the ride and are now happy to exit their trades when the conditions surface which satisfy their exit requirements, especially when the price drops off its high enough for their tastes and strategies.

This does not mean that the party is over, and once again, IPOs can keep going up well past their initial period, although at this point we enter the territory of more established stocks to some degree anyway, with more normal periods of consolidation along the way, where the price may pull back or go sideways for a time before initiating another advance.

Not all IPOs succeed though, and when they go wrong, due to the greater volatility of IPOs in general, they can go more wrong so to speak, and therefore IPOs require a higher standard of care than normal stocks.

Even if the IPO has run up successfully, once things settle down, they have the potential to drop faster as well, and one who is not careful enough can see their profits diminished significantly if the goal is to capture them but not enough attention and discipline are applied.

IPOs can certainly be exiting regardless of whether your time frame is very long term, very short term, and everything else in between. The mere structure of IPOs dictate this, as they are of a lesser known quantity than normal stocks and when there is uncertainty, risk, there often is greater potential for rewards as well.

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.