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. An initial public offering is the first time shares of a company go on sale to the public. IPOs 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 end up sinking 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 hot? 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 look at some of the best-performing IPOs over the past year:

Don't rack your brain looking for a common theme. The winners come from all walks of life. Aegean refuels ships on the high seas. Double-Take's specialty is data protection. Amercan Public Education runs vocational post-secondary schools. Genoptix is a provider of clinical laboratory diagnostic services. BladeLogic makes data center management software.

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 Aegean opened just a buck higher at $15 the day it went public. The market can't get enough of it now, but it briefly traded below its IPO price two months after its market debut.   

Sometimes a hot IPO shows its winning ways right away. Giant Interactive (NYSE:GA) went public at $15.50 last month, popping up to $18.25 at the open. The fast-growing player in China's online gaming market may have stumbled lately along with other companies in its niche, but the growth prospects remain promising.

Brands like BladeLogic, along with investing themes like for-profit education and data protection, 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
Naturally, there are plenty of dogs in any IPO litter. Noah Education (NYSE:NED) went public last month at $14 a share. It opened at $22.90 but is already down to trading in the single digits. Retooling China's workforce is a story that is easy to embrace, but Noah's first quarterly report as a public company disappointed investors.

I weed out the potential portfolio-killers by looking for warning signs.

• Is the IPO an exit strategy? It could be if there are too many executive insiders selling.
• 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 wanes. It's as if they've heard the last-call order from the bartender and rush like they're scrambling for 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 dips into the basement. However, getting in early is the best way to enjoy the long 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 recommended several fresh IPOs to newsletter readers. He does not own shares in any company 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.