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 "layup" 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 of 2006:

Don't rack your brain looking for a common theme. The winners come from all walks of life. MasterCard is the credit card titan whose plastic may very well be sitting snugly in your pocketbook. New Oriental is in an ideal situation: providing private educational services in the booming Chinese economy. Acme is a networking equipment maker.

Vanda and Osiris are biotechs, but they're not the same. Osiris is working on stem cell research, while Vanda is seeking cures for central nervous disorders.

So what ties all of these hot issues together? It wasn't necessarily pent-up market demand. Despite being a household name, MasterCard popped just 18% higher on its first trading day. Vanda actually dipped below its offer price, closing 3% lower as a market debutante.

Brands like MasterCard and investing themes like New Oriental 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. MasterCard never lost its halo because it has obliterated Wall Street's profit targets in each of its three quarters as a public company.

Fresh winners can do a portfolio good. Two of the hottest 2006 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 for 2007? It will if you accept the nuances behind the disparity. The blazing biotechs earned their stripes by lapping critical clinical trial milestones. The other three 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 were naturally plenty of dogs in 2006. Alphatec Holdings (NASDAQ:ATEC) has shed 60% of its value since going public last June. The medical device maker has clearly been a disappointment. Last week it posted a loss on a mere 8% top line advance.

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. Xinhua Finance Media (NASDAQ:XFML) faltered as an IPO last month. It is trading well below its $13 IPO price today. It was hoping to cash in on investing appetite for Chinese stocks. Yes, Xinhua is a leader in personal finance reporting in China, but that isn't the kind of growth market as some of the country's more successful new issues. Keep on eye on the many other Chinese IPOs and alternative energy players angling to go public this year. Make sure that they're 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 almost as if they hear the "last call" order from the bartender, so they rush to go public. 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 for their presence in 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 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. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. New Oriental is a Global Gains recommendation. MasterCard is an Inside Value selection. The Fool has a disclosure policy.