Just because you want your company to have an IPO doesn't mean you should invest in someone else's. Unless you do it like this.
Let us once again praise the Great American IPO machine. Seriously. The U.S. market for initial public offerings is the envy of the world, a mighty engine for building companies, creating jobs, and driving economic growth. To entrepreneurs, IPOs offer the promise of funding for their businesses and rewards for their hard work. For the general public, the IPO market can spotlight capitalism at its dynamic, meritocratic best.
Too bad it's no place you should ever invest.
Now, you probably weren't surprised when your brother-in-law burned his fingers flipping hot IPOs in the late 1990s. The guy saw tech shares doubling in their first day of trading, and since he couldn't get any at the issue price, he bought the next day and planned to sell when the things tripled. That strategy actually worked for a while, but one morning in late 2000 he looked in the mirror and saw the Greater Fool himself staring back. And as the Nasdaq dove, the IPO machine shuddered to a near halt. There were only 83 new issues in 2001, down from 406 in 2000.
But you're no day trader -- just a sober long-term investor with a bedrock belief that getting in on the ground floor of the next Microsoft is worth some time and effort. The trouble is, separating the future giants from the new-issue fads isn't easy, according to Jay Ritter, a University of Florida finance professor and IPO expert. Ritter says that if you'd bought into all the 7,396 IPOs from 1970 through September 2000, your average annual rate of return (based on an end-of-first-day price and a five-year holding period, with a minimum of one year for the most recent issues) would have been 10.6%. That's well short of the 14.1% you could have gotten -- far more safely -- by buying similar-sized companies that were already public.
And yet, and yet: those 7,396 new issues included not just Microsoft but Wal-Mart, Genentech, and Cisco. With the market for new issues finally showing signs of thawing -- PayPal, a dot-com, even got a rousing reception in mid-February -- isn't there some way to invest early in the next great growth stories? The answer is, sure -- provided you maintain a healthy caution about the IPO machine itself and, most important, adjust your definition of early.
First the machine. The key thing to know about the IPO market is that it is like the broader stock market, only more so. It is --
More cyclical. When the outlook is sunny, investors snap up shares in speculative companies, and Wall Street gleefully finds more and more IPO candidates, lowering its standards as necessary. Come the inevitable bust, investors recoil from all but the strongest entrepreneurial companies or the big corporate spin-offs like Kraft, floated by Phillip Morris last year. "This sector gets best when people are most pessimistic," says Bill Smith, president of Renaissance Capital, a Greenwich, Conn., research and money-management firm specializing in IPOs.
More volatile. That means higher highs and lower lows, with crazy gyrations in between. For evidence look no farther than Smith's own mutual fund, called IPO Plus Aftermarket Fund, which posted a 115% gain in 1999 followed by a 42% loss in 2000, a 52% plunge in 2001, and a 7% falloff in the first six weeks of this year.
More tilted toward the pros. Got a fat account with a full-service broker? Great. You may actually get a few IPO shares at issue price and enjoy the quick 10% or 15% run-up that such securities are traditionally priced to deliver. If you hang on to them, you may even get a sliver of a future deal. But accept that underwriters reserve the bulk of their IPO allocations for their best clients: managers of mutual funds, hedge funds, and other institutional money. The mechanics of launching new issues are such that buying them fresh (and flipping them fast) is going to remain a perk for the pros.
Which brings us to the matter of timing. Professional traders may be able to make money plunging in and out (and going long and short) at the beginning of a stock's life. What's your hurry, though? Go back to that Microsoft example. A year after the company's March 1986 IPO, you might have felt as if you'd missed the boat. That's because by March 1987 the stock had nearly quadrupled, from $21 to $83 a share. But the best was definitely yet to come. Recently, that share (now 144 shares thanks to eight splits) was worth nearly $9,000. A similar pattern holds for most of the other big winners, confirms Jay Ritter. By waiting you may limit your upside a little, but you can limit your downside a lot. Lockup agreements, which prevent insiders from selling, usually expire after 180 days. Don't you want to see how the stock weathers that process? (Usually, it trades down a bit.) How about another few quarters of financials, to see how the attractive face that every company puts on at offering time holds up? Many companies go through a sort of sophomore slump, with their stocks getting pounded when they fail to deliver on optimistic projections. That can warn you away from bad businesses -- or create buying opportunities in good ones.
No, you can't wait forever -- not without giving up the growth-stock characteristics that brought you to this neck of the investing woods in the first place. Nor is there any rule for when it becomes reasonable to buy a new stock. A $100 investment in Wal-Mart half a year after its 1970 IPO would be worth around $225,000 at recent prices; if you'd waited another two years to decide whether this Arkansas retailer was for real and then invested your hundred bucks, your return would be a respectable $160,000. Had you put $100 into Cisco a week after its February 1990 IPO, you'd own shares worth about $25,000 at recent prices. If you'd read up on networking for a year before taking the plunge, you'd have to settle for about $10,000.
And so on. As with any investment, there are many factors to consider, from industry dynamics to the all-important question of valuation. Just don't let any false sense of urgency distract you. Oak trees really don't grow overnight.
Financial writer Kenneth Klee started trying to figure out the stock market more than 20 years ago and has since edited and written for such publications as Institutional Investor and Newsweek. If he'd known back then what he knows now, he's pretty sure he would have invested in the companies discussed here.