What you need to know (but don’t) about buying an IPO

An initial public offering of a stock, called an IPO, can be either a sucker’s game or a chance for instant riches. Determining the outcome requires a great deal of work, knowledge, and luck. Most investors have none of the above when it comes to IPOs.

I want to share with you a recent conversation I had with a conservative client (a vegetarian and yoga teacher) on this subject.
“I want to buy some stock of this company that makes a vegetarian form of hamburgers. How do I do it?” she asked.

“Why do you want to buy it?” I asked, before explaining the mechanics of such a purchase.

“Well, it tastes really good, all my friends love them, so I’m sure it’s going to be a great stock since more and more people will switch to this healthy choice of food.”

What’s wrong with this picture?

Number one, her analysis is full of holes. Her first mistake is failing to recognize three crucial differences. A good product does not necessarily translate to healthy corporate profits. Many a company with a good product has failed miserably because they did not have the knowledge, experience and financial acumen to make a go of it as a public company in a competitive marketplace.

Number two, it does not necessarily follow that a company with good fundamentals will also perform well in the stock market. There are thousands of cases throughout financial history where companies that IPO never again reach their offering price.

And three, if you think it is hard enough to analyze the fundamental valuation and technical position of an already-established public company, imagine the difficulty in trying to do the same for a company with no historical data, and even worse, that sells a new or innovative product that is little understood.

Let’s look at some of the other mistakes in financial logic my client is making. How many vegetarians are there in the U.S. versus meat eaters? The latest research (2017) put the number at 7.3 million Americans or 3.2% of the country’s population. That’s not a very big market, but she believes that once more people “discover” this non-meat burger, they too will find religion and give up meat.

Going public, however, won’t change that. This particular company is already distributing its products (non-meat, non-chicken and non-sausage) in dozens of national food chains and stores throughout the nation and overseas.

She also needs to recognize that if this plant-based array of products is so good, competitors won’t just sit still, they will imitate and offer their own plant-based products. In this case, it is already happening. Burger King is marketing a meatless “Impossible Burger.” Reports indicate it is at least as tasty as my client’s company’s product.

Buyers of IPOs should also be aware that these offerings are normally handled by big brokerage houses that know how to promote a new issue and will, for a short time, support its price. Normally, brokers insist that company insiders have a “lock-up” period for a few months before owners and employees can sell their stock. When the lock-up period is over, an avalanche of sell orders hits the market. A look at most IPO stock prices a few months after going public shows a steep drop in price, most often well below the offering price.

Some retail investors don’t care because they are planning to “flip” the stock. You buy the IPO after it begins to trade (usually at a higher price than the initial offering price), and then sell it for a profit over the next few days. That’s where your luck comes in. Your odds of making money are equal to how much hype there is surrounding the stock.

Don’t be fooled, some IPOs do skyrocket and never look back. You can take your chances, or have some patience, wait a few weeks or months and then, after doing your homework, make your investment. It’s not as exciting, but it has been proven to be a better investment style over time.