How to Get In on an IPO
A Motley Fool Special Report

By Yi-Hsin Chang, TMF Puck

Special Feature

Part 1
What IPOs Are and Why They Happen

Part 2
How to Get In on an IPO

Part 3
New Ways Companies Are Issuing Shares

Talk About IPOs and This Special on the IPO message board

You know the expression "I'll give my first-born?" Well, that's not too far a stretch from what it takes to get a piece of a "hot" IPO.

One of the most common questions asked in email to the Fool is, "How do I get in on an IPO?" As an individual investor without tens of millions of dollars to invest, you can see why, in the minds of stock brokers, you're pretty low on the totem pole. After researching the company and putting together a prospectus, the investment bankers underwriting an IPO take their clients on a "road show" (also known as a "dog and pony show") to attract buyers. The reason you've never been invited is because you're simply not the target audience. Investment bankers spend their time wooing analysts and large institutional investors, not individual investors.

Here's the catch: If the bankers think a stock will soar, they earmark much of the shares for their favorite institutional clients (ones that bring in the most in commissions). In a sense, brokerages use lucrative IPOs to curry favor with big clients, to win and retain their business. When brokers aren't so confident about the company's prospects, they will try to sell the stock to less-favored institutional clients. Clearly, the rich get richer, while the average investor gets left out.

Keep in mind that the underwriters' main customer in an IPO is the company going public. Don't think that they're doing you any favors selling you shares. If you're able to get your hands on some shares, it probably means that nobody else wants them, and you shouldn't either. Of course, there are exceptions, so do your own homework before passing up what might be a good buying opportunity.

If you're determined to try to get a piece of an IPO, you basically need to have an account with one of the underwriters. This could conveniently mean your existing broker, or it could mean you'll have to set up a new account with another broker. Check with your existing broker first, and then check the offering prospectus for a full list of underwriters. Of course, there's no guarantee that you'll actually get in on the IPO or get your hands on as many shares as you want.

Hazards of 'flipping' IPOs

If you want to get in on an IPO so that you can "flip" the stock -- that is, resell it for a quick profit -- while it's hot, be forewarned: it's not as easy as it sounds. First of all, chances are your broker will "strongly encourage" that you hold on to the stock for at least a month or two. While there's no rule prohibiting you from flipping the stock, you'll probably be blacklisted for future offerings if you do. So if you cash in on your profit now, you risk being shut out of future IPOs.

The reason brokers, including online brokerages, discourage clients from flipping IPOs is that they themselves don't want to be shut out of future offerings or lose commissions because too many of their customers flip stocks. The companies going public prefer to have long-term shareholders, not a bunch of day-traders looking to "earn" a quick buck.

Lest you get the wrong impression, the rule just described does NOT apply to institutional investors, who routinely flip stocks at will without being "punished." While it's terribly unfair that institutional investors operate under different rules from individual investors, you won't get much sympathy from these quarters on the issue of flipping. After all, Fools believe in investing for the long term, and flipping IPOs is downright unFoolish.

Why you should avoid IPOs

Aside from the pitfalls already mentioned above, the whole process of taking a company public -- distributing a prospectus, going on a road show, doing interviews with the media, etc. -- is one big hype job for the company in question. Sometimes it's the most attention a company will ever get.

It's easy for investors to get swept up in the hype, to perceive the IPO as some sort of once-in-a-lifetime opportunity, to forget that the company will be publicly traded and its shares readily available on the open market. Keith Pelczarski (TMF Czar), who spent his pre-Fool days working with IPOs at a major brokerage firm, once said, "Investors are drawn to these hot issues like moths to a flame, and just like those moths, many get burned."

A good rule of thumb is: If you don't get in on an initial offering, don't be sucked in by the hype and buy shares of an IPO on its first day of trading. More often than not, you'll end up buying at an inflated and unsustainable price. If the stock is worth owning, it will most likely be worth owning weeks, months, or even years after the hype has died down.

Case in point: I was interested in the Fox Entertainment IPO last November. Knowing that the heavily touted issue would be hard to come by, I waited it out. Despite a slight initial run-up in the stock price, I was able to buy shares at the IPO price about a month after the company went public. In fact, after I made the purchase, the shares dropped further, falling as low as $3 below the IPO price of $22.50 a share. The moral of the story: Save yourself the headache. You can make money without ever participating in an IPO.

Generally speaking, most decent IPOs will experience a price run-up immediately after they start trading, only to come down to a more rational level once the buzz dies down. One study showed that investors who bought shares of an IPO at the closing price on its first day of trading saw a 2% annual return on the investment. In short, you'd be better off keeping the money in an interest-bearing savings account.

On average, IPOs make bad investments. A study by two university professors a few years back looked at 4,753 IPOs and 3,702 secondary offerings made between 1970 and 1990. In the six months following the offering, IPO firms lost 1.1%, versus a 3.4% gain for matching firms that made secondary offerings. The new issues continued to underperform over the next three years, with the gap narrowing but persisting well into the seventh year following the IPO. During the 20 years covered by the study, the average annual return over the five-year period following the offering was 5.1% for the new issues and 11.8% for the comparable firms.

Not surprisingly, companies make offerings when the market is up, when business is going well -- essentially, when they can sell shares at the highest price possible. In other words, don't expect a bargain in an IPO. More likely than not, you'll be getting shares that are closer to being overvalued than undervalued.

Next -- Unconventional IPOs