How to Spot the Next Hot IPO

The only thing better than buying into a great company is doing so 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 promptly sink into the basement. Some "can't-miss" and "lay-up" 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 some of the best-performing IPOs to recently hit the market:

Don't rack your brain looking for a common theme. The winners come from all walks of life. Gushan is an environmental play. Intrepid Potash manufactures potash for the agricultural and oil industries. IPC is a physician services provider. CardioNet monitors outpatients. ATA is a Chinese e-learning company.

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. CardioNet closed below its $18 IPO price on its first trading day. A week later, the shares were trading even lower. Redemption came after investors flocked to the shares gradually.

Lumber Liquidators (NYSE: LL) has had an even wilder run. The retailer of discounted hardwood flooring went public at $11 in November. Two months later, it bottomed out at $5.68, with investors fearing that the moribund housing market would chop up the chain. It didn't. Lumber Liquidators thrived, generating stellar profit growth. Shares hit a new high of $16.55 this week.  

Sometimes a hot IPO shows its winning ways right away, of course. Intrepid Potash went public at $32 last month, popping up to $50.40 at the open.

Brands like CardioNet and Lumber Liquidators, along with investing themes like energy and China, 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 the hottest IPOs from 2006 are 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 they're 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, then went on to cement that perception with heady quarterly growth performances.

The pitfalls of IPO investing
There are naturally plenty of dogs in any IPO litter. Real Goods Solar (Nasdaq: RSOL) went public last week, priced at $10 a share. The stock opened at $9 and just kept dropping. Shares actually closed lower in each of its first five trading days, for a cruel 28% loss for its initial investors. The market apparently loves solar energy plays when they're Chinese photovoltaic panel makers, but not when they're West Coast residential system installers.

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 when 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 it has heard the last-call order from the bartender and is 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 while the market corrects itself, 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 he's 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. The Fool has a disclosure policy.