Should You Stop Buying New Stocks?

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Lots of investors flock to initial public offerings (IPOs) as if they were the latest stylish restaurant. Lately, though, certain types of IPOs have given buyers a big case of heartburn, making some question whether it's time IPO investors faced reality.

The other side of the trade
According to Bloomberg, returns on new stock IPOs from private equity firms are losing money for investors for the first time in at least 10 years. Perhaps more surprisingly, private equity's offerings are underperforming the broader range of initial public offerings so far this year.

The reason that's a surprise has to do with the way that most IPOs are orchestrated. Typically, getting shares at an IPO's official offering price is next to impossible for regular investors, as underwriters tend to reserve them for high-end clients. The first chance that average investors have to pick up shares is when they start trading on the open market. If underwriters do a good job of stoking demand and limiting first-day turnover, then shares will often jump in their first trading days.

Historically, the most successful IPOs have been those that have created the most pre-offering buzz. Perhaps the best example in recent years is Google (Nasdaq: GOOG  ) , which went public via a unique Dutch auction process that gave individual investors a chance to include themselves among the often-exclusive club of direct IPO buyers. After going to bidders for $85, Google shares closed 18% higher on its first trading day and never really looked back.

Dealing with the blues
By contrast, now hasn't been the best time for companies trying to do successful IPOs. With the overall stock market having dropped more than 10% in just over a month and the Dow having experienced its worst May in 70 years, even promising new companies struggle to stay out of the downdraft. Metals USA (NYSE: MUSA  ) , a steel processing company, has seen its shares fall from their $21 offering price in early April to just $15.30. Similarly, direct IPO buyers paid $20.50 for shares of Niska Gas Storage (NYSE: NKA  ) , but they fell their first day of trading and now are priced under $19.

Part of the problem comes from the urgency of the private-equity investors who are selling stakes in these companies through IPOs. Firms like Blackstone Group (NYSE: BX  ) and Apollo Global Management face pressure to repay debts incurred when they took over companies, and raising money by offering shares in these companies is the usual exit strategy. They've even been willing to take some dramatic cuts in IPO price just to get deals done; with Noranda Aluminum (NYSE: NOR  ) , for instance, Apollo cut the size of its offering by 40% and slashed its offering price to $8 from its initially expected range of $14 to $16.

What investors may be realizing from the Goldman Sachs fraud allegations is that whenever you buy a stock, there's another party that thinks it's worth selling. And when the stock market goes down, making shares of companies that have traded on stock exchanges for years more attractive, untested IPOs have to compete even more to attract investor attention.

Staying on the sidelines
Until the stock market stabilizes, you can expect to see more companies choosing to delay or cancel IPOs. The question, though, is whether private equity firms can afford to wait. Several major deals are still expected to go through later this year. Judging from recent experience, private equity firms may be willing to make huge concessions to get deals done.

All of this is good news for discerning investors. Rather than having to face the carnival atmosphere of IPO shares getting bid into the stratosphere, you have time to make an objective assessment of a company's future prospects before committing your capital. If you're lucky, you may also see your patience rewarded with a discount in share price -- one that will hopefully disappear if the overall market's woes evaporate.

Sometimes, old stocks are the best stocks. Find our from Fool contributor Morgan Housel which four stocks you should buy after the crash.

Fool contributor Dan Caplinger isn't on anyone's IPO list, although he did get to try some free samples of a new cracker at the grocery store over the weekend. He doesn't own shares of the companies mentioned in this article. Google is a Motley Fool Rule Breakers pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is an instant classic.

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