How to Find Value in Busted IPOs

Poke around in the stock market long enough, and you'll eventually find a backwater of forgotten and unloved companies nestled away from sight. If you take the time to sift through enough of them, you might find a couple of keepers. Those are the ones that value investors often refer to as "busted IPOs," and they're worth paying attention to, since busted initial public offerings can become extremely undervalued.

IPO bonanza
First, we need to discuss the IPO process. When a company goes public, it usually gives an investment bank a cut of the proceeds -- maybe 5% to 7% of the amount raised -- in exchange for help with raising capital. Then the investment bank, using its distributional might and an army of brokers, takes the management team on a song-and-dance road show to drum up interest.

If there's enough interest, the IPO becomes something like the opening night for a hot new restaurant or nightclub -- the kind where the line stretches out the door.

For example, Rule Breakers and Motley Fool Hidden Gems recommendation Chipotle (NYSE: CMG  ) priced its IPO at $22 per share, but demand was so strong for shares that the lucky few who actually had the connections and clout to get shares at the IPO price from their brokers saw their shares double on the first day.

Busted!
That's the ideal scenario for an IPO. However, not every company can capture the wallets (and stomachs) of investors the way Chipotle can. When an IPO falls, it often falls hard. And it can do so for a number of reasons.

Lack of attention
If the company isn't a blockbuster like Google (Nasdaq: GOOG  ) or a household name like MasterCard (NYSE: MA  ) , its IPO will probably receive scant attention from Wall Street or CNBC. Thus, many potential investors often don't even know the company exists.

No confidence
In addition, IPOs often don't have much of a track record or fan base to fall back on. If a blue chip such as General Electric (NYSE: GE  ) has a bad quarter or series of quarters, then investors may shrug it off because of the company's extremely long track record of profitability and operational excellence.

On the other hand, when a company such as Heelys (Nasdaq: HLYS  ) , which has been public for only about a year, posts disappointing results, investors stampede for the exits. Shares currently trade at $6, down from the IPO price of $21.

Garbage in, garbage out
Many investors often buy shares for unsophisticated reasons. Some investors buy shares because their brokers tell them that it'll be the next Chipotle or Baidu (Nasdaq: BIDU  ) and will therefore be "easy money." If the shares don't soar on the first day, then investors start becoming disillusioned.

If, in the next couple of months, the shares start to slide, suddenly you have the potential for a mass exodus, as many unsophisticated buyers, who know almost nothing about the company, all decide that they want out at the same time.

The opportunity
I often wade through the sea of busted IPOs to see whether anything looks interesting. If you'd like to do the same, keep an eye out for a few things:

  • A big cash hoard. When a company IPOs, a portion of the cash that gets raised sometimes goes directly onto the balance sheet. If shares fall, then you suddenly have a situation in which cash represents a large portion of the market capitalization.

    For example, I noticed that Heelys has $90 million in net cash and a $162 million market cap. Although the company's business model is based solely on a faddish product, the large cash hoard makes the company interesting enough to warrant at least a closer look.
  • A long operational history. Although IPOs have very short track records as public companies, they can often have very long operational histories. For example, although MasterCard had its IPO in 2006, the company's history stretches through several decades.
  • A strong brand name. Pzena Investment Management's (NYSE: PZN  ) shares have slid from their IPO price of $18 to below $11, partially because of redemptions at one of the company's flagship mutual funds. However, Pzena has a strong brand name within value-investing circles and has historically grown very rapidly, so I'm inclined to keep an eye on it.

Foolish thoughts
Researching busted IPOs is kind of like looking through the bargain bin at the clothing store. Although you'll find a lot of low-quality items, a real gem occasionally slips through. I'd advise Fools to take a glance at the busted-IPO sector once in a while to look for large cash hoards, strong brands, and solid operating companies.

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