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 "lay-up" IPOs wind up as nothing more than airballs.

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 some of the best-performing IPOs over the past year:

IPO

Gain

LDK Solar (NYSE: LDK  )

$27.00

170%

KBR (NYSE: KBR  )

$17.00

129%

MercadoLibre (Nasdaq: MELI  )

$18.00

106%

WuXi PharmaTech (NYSE: WX  )

$14.00

116%

Dolan Media (NYSE: DM  )

$14.50

70%

Don't rack your brain looking for a common theme. The winners come from all walks of life. LDK is riding the hot alternative energy movement. KBR is an infrastructure management specialist. MercadoLibre runs a popular South American auction site. WuXi is a Chinese pharmaceuticals company with a biotech bent. Dolan Media is a trade publisher with a little sizzle on the legal services side. In short, you are unlikely to see these five companies rubbing shoulders at any particular industry trade show.

So, what ties all of these hot issues together? It isn't necessarily pent-up market demand. Shares of KBR closed for less than its $27 IPO offering price in nine of its first 10 days as a public company. The market can't get enough of it now, but it wanted nothing to do with KBR in early June.  

Sometimes a hot IPO shows its winning ways right away, of course. Physician billing software developer athenahealth (Nasdaq: ATHN  ) went public at $18 a share last week, popping to an open of $30. It kept going from there, closing at $35.50 at the end of its first trading day. It happens, but just know that slow starters can also become lucrative speedsters.

Brands like MercadoLibre, along with investing themes like solar energy and biotech, 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.

Fresh winners can do a portfolio good. Two of last year's hottest IPOs 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 from now on? It will if you accept the nuances behind the disparity. Most of the hotties came to market as quality players that went on to cement that perception in their heady quarterly growth performances.

The pitfalls of IPO investing
There are naturally plenty of dogs in any IPO litter. Dice Holdings (NYSE: DHX  ) went public two months ago at $13 a share. It closed in the single digits last week. The company behind several tech job websites deserves better. Its first quarterly report as a public company was superb, with revenue soaring 79% higher. Operating profits clocked in even higher. Unfortunately, it's toiling away in a lukewarm sector, and the company had a rocky history in its original publicly traded incarnation.

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. Make sure that new stocks are as good -- if not better -- than their publicly traded peers.
  • Is the valuation realistic? Underwriters often reach too high for a company where the prospects are much lower. 
  • Is it a forced IPO? I hate it when a company rushes to go public as niche enthusiasm is waning. It's as if they've heard the last-call order from the bartender and rush to go public like they're scrambling to order one more beer. 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 why we pluck 'em early for 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've 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.

This article was originally published on March 10, 2007. It has been updated.

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. Rick is part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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