How to Spot the Next Hot IPO

The only thing better than buying into a great company is buying into a great company early in its growth cycle. Initial public offerings (IPOs) are the first sale of a company's shares to the public. They give investors like you and me a shot at an early arrival, but it's never quite as easy as that.

Many ground-floor opportunities head lower into the basement. Some "can't miss" and "layup" IPOs wind up as nothing more than air balls.

You can help your cause by learning to spot the differences between the winners and the losers. What makes a hot IPO great? What are the warning signs of a debutante stinker? Let's dive into the answers you need.

Anatomy of a hot new stock
The best way to unlock the secrets of tomorrow's big gainers is to dig into the market-thumpers of the past. Let's take a closer look at the five best-performing IPOs of 2006:

Don't rack your brain looking for a common theme. The winners come from all walks of life. Riverbed is revolutionizing the computer networking space with its Steelhead product, which dramatically boosts the speed of wide-area networks. Home Inns & Hotels is cashing in on a Chinese market that's just starting to discover the middle-class joys of traveling. Chipotle Mexican Grill is, quite frankly, the creme de la creme of quick-service burrito shops.

Omrix and Acorda are biotechs, but they couldn't be further apart in scope. Omrix is a blood plasma and biosurgery specialist, while Acorda is inching ahead in its quest to conquer multiple sclerosis.

So what ties all of these hot issues together? It wasn't necessarily pent-up market demand. Sure, Chipotle doubled at the open, but that wasn't always the case. Omrix closed out its first day as a public company at $10.30, a mere 3% pop. Acorda's stock was fetching a little more than half of its original $6 IPO price when it bottomed out over the summer.

Brands like Chipotle and investing themes like Home Inns will provide an early advantage, but these success stories wind up earning the market's faith by producing strong quarterly results early in their tenure. Chipotle never lost its halo because it has obliterated Wall Street's profit targets in each of its five quarters as a public company.

Fresh winners can do a portfolio good. Omrix and Chipotle are recent recommendations in the Rule Breakers newsletter service. The growth stock research service didn't get subscribers in on the offering price, but both stocks have beaten the market since being singled out.

So what have we learned? Hot IPOs come from different sectors and are saddled with different investor expectations. Will that help you land the winners for 2007? It will if you accept the nuances behind the disparity. The blazing biotechs earned their stripes by lapping critical clinical trial milestones. The other three came to market as quality players that went on cement that perception in their heady quarterly growth performances.

The pitfalls of IPO investing
There were naturally plenty of dogs in 2006. Vonage (NYSE:VG) was the worst IPO of 2006 with its 59% tumble, but several other companies also fell short, despite prospectuses brimming with potential.

I like to weed out the potential portfolio-killers by looking for a few warning signs.

• Is the IPO an exit strategy? If there are too many executive insiders selling, it may be.
  
  
• Is this an inferior company trying to ride coattails? Many investors learned this the hard way in the dot-com bubble days, when pretenders like Pets.com and Webvan collapsed. Digital Music (NASDAQ:DMGI) faltered as an IPO last year. It was hoping to cash in on the popularity of digital distribution, but it simply lacked the content library to make a material difference. Keep on eye on Chinese IPOs and alternative energy players this year. Make sure that they're as good -- if not better -- than their publicly-traded peers.
  
  
• Is the valuation realistic? I'm not going to bash Vonage. There may be still be hope out there for the edgy communications specialist. The problem is that the IPO was priced too richly. Underwriters failed to discount the company's lack of profitability and the threat of rapidly emerging competitors.
  
  
• Is it a forced IPO? I hate it when a company rushes to go public as niche enthusiasm is waning. It's almost as if they hear the "last call" order from the bartender, so they rush to go public. Whether it's a nervous private equity firm or a cash-strapped upstart, I avoid those "me too" copies like the plague.

So where does that leave you? The IPO pipeline is never dry. There may be fewer new issues going public when the market is correcting, but quality ones find a way to earn their ticker symbols.

Don't let new stocks scare you. The Rule Breakers newsletter has recommended several new companies, in some cases just weeks after their market debuts. You're welcome to read up more on the reasons for their presence in the growth service's scorecard. A 30-day trial subscription will get you in for free.

Getting in early has its risks, of course. We already explored how that ground-floor elevator sometimes stops down in the basement. However, getting in early is the best way to enjoy the longest ride up to the penthouse.

Longtime Fool contributor Rick Munarriz is a fan of new stocks and has even recommended several fresh IPOs to newsletter readers in the past. He does not own shares in any of the companies mentioned in this story. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. Chipotle is also a Hidden Gems recommendation. The Fool has a disclosure policy.