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 airballs.

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 hit the market over the past year:

Don't wrack your brain looking for a common theme. The winners come from all walks of life. Yes, Concho, Rex, and SandRidge are all energy exploration companies. That is certainly a hot trend as oil prices spike higher. However, Titan Machinery is a dealer of agricultural equipment to farmers. MSCI is a portfolio analytics specialist.

In short, you are unlikely to see all of 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. Rex Energy closed below its $11 IPO price on its first trading day. Shares spent the next five months trading mostly in the single digits. Redemption came as investors gradually flocked to the shares.

Sometimes a hot IPO shows its winning ways right away, of course. That's what happened to Titan Machinery. The stock opened at $14, well above its $8.50 IPO price tag. It hasn't looked back since.

Lumber Liquidators (NYSE:LL) has enjoyed an even wilder run. The leading retailer of discounted hardwood flooring went public at $11 in November. Two months later it bottomed out at $6.07, with investors fearing that the moribund housing market would chop up the chain. It didn't. Lumber Liquidators thrived, generating stellar profit growth. Shares recently hit a new all-time high of $16.49.

Brands like MSCI and Titan, along with investing themes like energy and farming, 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 2006's hottest IPOs 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 handily 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, even if the themes make sense. Xinyuan Real Estate (NYSE:XIN) went public in December at $14 a share. Can't miss, right? China and real estate are like Diet Coke and Mentos. It certainly hasn't panned out that way; Xinyuan kicked off this trading week at $7.59, nearly half of its IPO price.

Internet Brands is another gravity victim. The company runs high-traffic Internet sites dedicated to lucrative areas like travel and auto research. Internet and valuable keywords would have been a potent combination a couple of years ago. It hasn't panned out so well for Internet Brands, which is trading well below November's IPO at $8 a share.

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 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 as if they've heard the last-call order from the bartender and are 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 March 10, 2007. It has been updated.

Longtime Fool contributor Rick Munarriz is a fan of new stocks, and he's recommended several fresh IPOs to newsletter readers in the past. He does not own shares in any of the companies 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.