GII: We hear so much about IPOs lately. What exactly is an IPO?

Todd Brown: An Initial Public Offering (IPO) is the introduction of a new issue of stock for sale to the public. Typically, a lead underwriter or group of underwriters first will solicit interest in a particular stock that is about to “go public.” Investors may place orders with the underwriting firms in hopes of purchasing the IPO within a certain price range. With the current IPO craze, average investors have no assurance that they will actually be able to purchase IPO shares. The ability to purchase depends on several factors, including the number of shares being offered, the number of investors interested in the stock, and whether the shares will be allocated by lottery, first-come-first-serve, or will be swallowed whole by institutional and wealthy investors before average investors can take a bite.


GII: What makes IPOs attractive to investors?

Brown: Publicity about huge gains in IPOs in the first day of trading and the lure of potential riches has increased interest in these new stocks. But many times, the most attractive IPO issues are bought up by institutions and wealthy investors and are not available to an average investor looking for a small number of shares. Average investors are more likely to buy a hot, over-hyped new stock when the price is high, only to be disappointed when it falls days or weeks later.

History has not been kind to new companies and the stock they issue. A 1997 Dun & Bradstreet study showed that 42 percent of all businesses fail during their first five years. Of those that survive five years, 25 percent fail after six to 10 years, and an additional 33 percent fail after 10 years. The average investor must remember that IPOs are typically issued for new companies lacking an established track record, an extremely risky investment inappropriate for investors seeking to achieve long-term goals such as retirement or providing for a child’s education.

GII: Some investors associate IPOs with Internet companies. Is the upside potential as great for companies in industry sectors other than technology?

Brown: Most of the recent IPO hype has been associated with Internet companies, as investors look to get in on the ground floor of the next big money-making technology stock. But there is no guarantee that any of these newly launched companies will be successful—or even profitable— businesses. As a group, new Internet stocks are some of the most expensive stocks ever traded, prices that are hard to justify when you examine current sales or the management team. Investors who wish to participate in the growth of the Internet would be better served by investing in established companies that are not totally dependent on the Internet for future growth, yet benefit from it.

GII: What risks are associated with IPOs?

Brown: New stocks don’t have the established track records, proven management teams, or clear competitive advantages that accompany blue-chip companies. Typically, investors must make their decision based on far less information as well. While new Internet companies will claim being first as a competitive advantage, investors should remember the experience of some of the first personal computer companies, with names like Apple, Osborne, Eagle and Commodore, later trounced by late-comers such as Compaq and Dell. In addition, IPO stocks are incredibly volatile. An investor may place a market order, expecting to pay the announced IPO price range only to have the order fill at a much higher price, which the investor is obligated to pay. A new stock may run up quickly for several days or weeks, only to retreat to a more “fundamental” price after the hype wears thin.

GII: When does it make sense for an investor to add IPO shares to a financial portfolio?

Brown: An investor who has risk capital to invest, with the understanding that the stock price could soar or drop quickly, might buy an IPO. This investor would typically hope to sell immediately after a quick gain in the stock. However, this strategy is not recommended for the average investor. Another investor who had done some careful research might decide to purchase a company’s stock for the longer term based on the fundamentals of the company or its industry. This strategy would include ignoring short-term fluctuations in the stock price.

GII: What advice would you give an investor who is determined to buy shares in a company that is about to go public?

I would warn an investor that he or she is taking a calculated risk and should only spend money he or she can afford to lose. First of all, the stock might cost far more than the quoted IPO price range, and second, lightning-fast shifts in the price are possible once the stock is freely traded. I would urge the investor to do some serious homework, obtaining and reading the company prospectus to make an educated decision.

If the investor was determined to proceed, I would suggest that if the IPO price can’t be obtained, the investor submit a “limit order” stating a maximum price he or she is willing to pay. Market orders are too risky as demonstrated by stocks that originally were offered at $15 or $20 only to hit $50 after trading begins.

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