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Why You Probably Couldn't Buy this Stock at $26 --
The Process of Going Public

by Jeff Fischer (TMF Jeff)

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 Lauren."

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 going public.

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 to please.

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 be.

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.

(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

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