Why You Probably Couldn't
Buy this Stock at $26 --
The Process of Going Public
by Jeff Fischer
ALEXANDRIA, VA, (June 12, 1997) -- So you couldn't get any shares
of Rainforest Cafe at the initial public offering price. Or Netscape. Or
Yahoo. Or Lucent Technologies. Or any popular company that has come public.
Last week you called your broker and tried to get your hands on a few shares
of Ralph Lauren before it hit the market, at $26 per share.
No dice. So you threatened your broker -- you told him or her that you'd
close your account and invest the money in a racehorse and a three-foot jockey.
The broker replied, "Go right ahead. I can't get you any shares of Ralph
You put down the phone and look at your dog. "What's the deal, Rex? I can't
buy stock in any popular company before it trades on the market, and I don't
want to buy it at $31 when other people could buy it at $26 beforehand. I
probably couldn't even buy PETsMART before the public offering."
Your dog barks, nods, and states, "I agree." You're too upset to realize
that your dog just talked.
So why can't you get shares of the hottest new stocks before they hit the
market? Well, for many reasons. Let's quickly first explain the process of
Initial Public Offerings (IPOs) are "brought to the market" by investment
bankers, which are hired by the company going public. The investment banker
is responsible for determining the value of the company and the resulting
stock. When an investment banker values a company and brings the stock public
it tries to be as efficient as possible -- meaning, it wants to raise the
most money for the company as possible, without losing any money itself through
the many risks involved.
If the stock trades below the initial offering price on the market, the
investment banker pays for it initially, through fees and other costs (including
losses on any shares it may control). Meanwhile, if the stock goes much higher
than the initial public offering price on the first day of trading, the
investment banker is embarrassed (because it arguably could have raised more
money for the company by pricing the stock higher). The client may not be
all that happy, either, and the investment banker could lose future business.
It's easy to surmise that pricing an equity and having that equity come to
the market is an exciting but hair-pulling day for any investment banker.
As a rule, the investment banker tries, in the end, to price the shares slightly
below what the market will pay for them, so that the investment banker can
please both the company it is selling for and the clients to whom it is selling.
But who gets to buy shares before they're offered on the public market? And
why is it never you?
The underwriting investment banker offers any available shares to its largest
clients -- usually institutional accounts like pensions or mutual funds.
In doing so, the underwriter is trying to keep the fattest cats happy.
On the retail level, which brokers and banks get a piece of any hot new stock?
Usually those that have a strong relationship with the underwriting investment
banker; or that are deserved a favor; or that the investment banker wants
The initial public offering market is a powerful force in forging and keeping
strong relationships (you scratch my back, I'll scratch yours), and thus
the stocks of good companies are very difficult to get your hands on before
they're available on the market, because the investment banker involved uses
the new stock as a business tool -- to build and develop beneficial relationships
with other heavyweights.
Further down on the retail chain, when brokers finally offer any remaining
stock to individual investors, it's usually only to the largest and most-monied
clients. Also, sometimes hot new stocks are used to attract new customers
-- i.e., "If you open a large account with us, the full-service broker, we'll
give you some shares of Ralph Lauren before they hit the market."
In the end, to get the hottest issues before they're available to the entire
market, you need to know someone. It's nearly as simple as that. Many hot
issues represent "quick money." More often than not a hot issue will open
substantially higher on the market from the initial public offering price,
so anyone who had shares beforehand has money in the bank immediately, if
they choose to sell. Getting shares of an in demand stock before the general
market can is like getting free money. How often has anyone given you
free money? Again, you usually need to know someone, and it helps if they
owe you a favor.
Is this right? Well, the underwriter takes the risk and puts up the capital,
so what it does with "its" shares is its business.
In the end, the largest question may be: do you want an IPO, even at the
IPO price? Historically, new issues have greatly underperformed the market
in their first five years of existence, by as much as 75% below the performance
of more established leaders, on average, annually. Those are dismal numbers.
So, should you rush to buy a hot new stock on its first day of trading? Just
in recent history, examples abound for the argument that you should wait.
Netscape came public at $28, but first traded at $72 (non-split adjusted).
Since then, the stock has been as much as twice as high, and nearly 50% lower.
Last month, Amazon came public and initially traded as high as $30,
but it now trades at $19. Yahoo leapt above $40 in its first few days,
then before long traded as low as $15, and is now around $32. Spyglass
soared above $30 in its beginning, from an IPO price of $17, and has since
gone as low as $14 (non-split adjusted prices). In the end, all of them have
underperformed the market significantly when measured from their first trading
price and compared to the S&P. In fact, all of them are down from the
prices reached on their first trading day.
Ralph Lauren came public at $26 but first traded above $31. The stock
movement, volume, and price performance appears to be something akin to the
initial action in Planet Hollywood stock, which hit $29 on day
one on heavy volume, and now trades at $20. Or Compuserve, which first
traded above $30 and is now around $10 per share.
Of course, we're comparing apples to oranges with general statements like
these, but many IPO's behave in like manner because peoples' emotions are
consistent -- meaning, initial excitement and even "hype," followed
by cooling off, and then, before long, the stock must sink or swim based
solely on the performance of the underlying business -- which is as it should
In most cases, you have plenty of time to buy a stock well after it has come
public and still reap the benefits of owning a winner -- in fact, in most
cases, you're better off waiting a number of years to see that the company
does indeed prove to be a winner.
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