Is it worth investing in IPO's in the aftermarket (i.e. public market) shortly after a new company goes public? Note this is a different question than whether one should invest in an IPO at the offering price before it is traded on a national exchange, since that option is not open to most investors.
There are four classes of IPO's:
- Spectacular Stories - everything is aligned for these guys to get great hype. They may be well known and growing, unknown but with a great story of potential growth, also rans but in a hot sector, or for some other reason on everyone's radar. These are almost assured to open at a price well above their initial listing, and they often take a good pop after that. Whether the continue up or tank is variable. They can make good volatility plays for traders and short term investors, and sometimes provide great long term holds. Once they peak, they can provide great shorts, but the initial short pile on leads to short covering and price appreciation, so be sure to wait for the peak.
- Blah - yeah, their financial model is ok, they're profitable in a reasonable market, but really, why bother? Given the high risk of failure, these sorts of plays don't usually compensate for those risks.
- Dogs - their financial model doesn't work, they don't know why they need the money or they are just trying to give your money to their original investors (not really true in the aftermarket, but it's the way you should think). The stocks of these guys are often manipulated in the aftermarket by the big players, and once that ends they can provide good shorts.
- Solids - old companies with proven financial models that for some well defined business reason need the public capitol markets. These can provide reasonable long term holds, and often do a slow rise. They are not hyped, just solid, and because of that they may not be on much analyst radar for a while, providing buying opportunities.
Beyond that company-specific sort of call, there are a number of IPO specific market dynamics to be aware of:
- Most IPO's fail - By this, I mean that after a year, and sometimes after much less, the stock price of the newly public company is below their debut price. This makes the IPO aftermarket exceptionally risky, as the likelihood of failure is high.
- Non-market forces - Big players (investment banks and management) likely have large stock holdings that they are either restricted from selling, or they may be incentivized to do a lot of buying. The initial market dynamics and players are often quite different after 30-180 days. Also the short interest in IPO's may be uncommonly high, and this often leads to violent short covering. That volatility can be good or bad, depending on your strategy.
- Sketchy financial performance common - many companies going public need the money for non-business enhancement reasons. Some have burned through so much money that their only lease on life is the public market. These guys used to never make it to the market, but that is not true any longer.
- Unknown plans and performance with the new cash - public companies with a track record have already shown what they do with their cash and whether they blow it or grow it. New IPO's may have untested management in this regard, and they often go awry. Unless you know something about their track record, you're betting, not investing. Sometimes betting they will fail has pretty good odds though (but look out for (2) above).
- Shorting may be difficult - say you've picked the perfect dog that has popped anyhow, so you want to short it. You are probably not alone in that idea, leading to the problem in (2) above, but in addition there may be restrictions on early big shareholders offering their stock for shorting, meaning it may be difficult for you (or your broker) to borrow the shares.
All of this can work to your advantage, if you manage to take advantage of it. The key here is that by far the most likely thing that will happen is that the IPO will fail (as per above definition). In addition, you know that the price will be manipulated for at least a month, and perhaps for the full lockup period (typically 90- days). So, what do you do?
Play volatility: If the manipulation does not manage to control the price, then you know the public market is in control rather than the underwriters, and whatever call you made on whether the stock should be a dog or a gem is more likely to pan out on its merits. (You could still be wrong, but that is always a problem!) If the stock has immediately tanked (unlikely) or skyrocketed (more common), there may be room for big counter-trend moves. This is a day-trader strategy, but is a pretty poor match for longer term players.
Look for stellar signals well outside the noise: You know the most likely thing is that the IPO will fail. When they don't fail, they often do spectacularly (e.g. GOOG, BIDU). The problem is finding that 1-2% of the offerings and only playing those. That means the company must have everything spectacularly aligned. These are often story stocks with big markets, big potential, and big hype. Sometimes they even have big profits and reasonable business models. When the hype and/or business is all aligned, expect a pop, until the first big drop, then expect the drop to continue.
The big point: given the huge risks, only bet or play when the stars are all aligned, and/or when you can short.