Here's What You Should Consider Before You Invest in IPO Stocks

There are plenty of reasons investors decide to invest in companies when it goes public or shortly afterwards. First and foremost, the possibility of getting in on the early stages of a company's growth story and capitalizing on that potential can be understandably alluring. However, not all IPO stocks are necessarily great investments. In this segment of Backstage Pass, recorded on Nov. 1, Fool contributors Danny Vena and Toby Bordelon discuss their personal theses toward investing in newly public companies. 

Danny Vena: Why don't we take a minute and look at Slido and see if there are any questions there that we could answer. The one that I'm going to take is from David Dudash here and says, "David Gardner thinks investors should wait a while to let the market digest IPOs even a year or so, any thoughts? I like to use Poshmark (POSH), but I sure am glad I didn't buy at its IPO." I have the same thoughts on IPOs because, honestly to me, buying a company right at IPO is more closely related to gambling than investing. You don't really know what's going to happen in the near term.

If it's a good business and you feel strongly about buying into it, buy a small position and wait it out, but learn more about the company, see how the market digests it as you say. But I generally don't buy on IPO until at least two quarters has passed, and I very rarely will make an exception. Usually, the one or two times that I have made an exception, I've gotten burned, so you can learn from my experience.

Toby Bordelon: I think that's right, Danny. I mentioned that before with Warby Parker (NYSE: WRBY) and they don't have any financials out yet as a public company. That's why I would like to see financials of the public company. When you've legit been public not just, "Oh, here's our performance is from our S1." I mean, not to say that people are deliberately misleading you, but it's just different running a public company.

You want to see a full quarter and we're not talking about, "Oh, release our second-quarter earnings three weeks if we're in a public." You want to see a full quarter of operations as a public company at least, I think. I like what you said about too before you make some serious. Now, that being said, look, if you are, "I love this business, I love this company. I'm going to buy a few shares." Okay, fine.

If I were going to buy at the IPO, I wouldn't approach that with the attitude of I'm buying my full position at the IPO. I'd maybe get a little bit because you just love the company and you want to follow the business. Fine. But study it and wait for a couple of those quarters of financials to start to learn more and see how things are just holding up. See how things are shaking out as they go public.

Vena: It's interesting. One of the things that I've noticed and because I write the weekly missive for the IPO Trailblazer service, I tend to go back and look at these companies that I've covered. One of the phenomenons that I see is the fact that when they submit documents to the Securities and Exchange Commission pre-IPO and you look at those growth rates, and then you go back after the first quarter, the second quarter, and look at those growth rates, almost invariably what you see is they have a really cleaned up copy of their financials that they put out right before the IPO and everything looked hunky-dory, and then all of a sudden right after, the IPO growth slows down.

How did that happen? Yeah, it's definitely a case of when companies are getting ready to go public, they're putting their best foot forward, and so they want to look the best they can but the blemishes start to appear after the first or second quarter financial reports are out.

Bordelon: I think that's right. Again, no one here is saying that we delivered fraud. It's just with accounting rules, there are some leeway. There are some estimates you have to make. There are some decisions you have to make as to how you're going to do certain things, and of course, when you put your S1 out, you're going to make it look as good as you can within the rules because you can make it look as good as you can. Nothing wrong with that, but just, as an investor, know that that's what's going on. Because if a company is not doing that, then you've got to wonder, who's advising you? Why would you not make things [laughs] look as good as you can when you're trying to get investors to buy your stock? That doesn't make any sense.

Vena: Well, when you're young enough to be dating, when you go out on a date, you're dressed up and you're wearing your Sunday meeting clothes, you got your hair cut and everything. Then compare that to several years later when maybe it's a Sunday and you've got your sweats on, and you haven't had a shower yet. [laughs]