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Star Spotting Among Fallen Ip Os

Personal Business: STOCKS


You could have bought shares of Box Hill Systems, a maker of data storage devices, for $15 each last fall in the Manhattan company's initial public offering. Today, though, the stock is changing hands for less than $10.

Does that sound like a steal? If it does, you're not alone in thinking so. Fallen IPOs can "become very valuable investments," says Manish Shah, president of Otiva, a new-issue research boutique and sponsor of the IPO Maven Web site (, a rich source of data. Indeed, David Solomon, a New York investor who made no profit on Box Hill despite buying in at its debut, now muses with hindsight that "picking over the IPOs that people have tossed aside might be a good strategy."

Sensible as buying busted IPOs may seem, however, it's decidedly contrarian in the current hot market for new issues. In one recent week, 11 new offerings hit the Street, including business lender Heller Financial and publisher Ziff-Davis. The 11 raised $2.2 billion, nearly 25% of the $8.9 billion raised so far this year, according to Renaissance Capital, a money manager in Greenwich, Conn. That amount is still behind last year's pace, but a long list of deals--including advertising agency Young & Rubicam and oil giant Conoco--will continue to rivet investors' attention.

You should be wary of purchasing IPOs because at the outset, they're usually more for traders than long-term investors. "The price of any IPO stock always comes down on the next trading day," says Calvin Lui, a West Bloomfield (Mich.) investor who bought Ziff-Davis and modem maker Broadcom, another recent issue, when they came out. He has since sold both. "The prices of IPOs are so inflated that it is not worth keeping them overnight," Lui contends.

Shah's statistics on 3,100 IPOs over the past four years tend to back this up. The problem with IPOs is that the earnings of 60% of them disappoint investors by their third quarter as public companies, Shah says. When that happens, fast-money, "momentum" investors dump the stock, and analysts turn their gaze elsewhere. Absent attention from the pros and liquidity, a new issue can often sink below the value of its underlying business. Solomon learned just that lesson with EarthShell, a maker of biodegradable packaging that he purchased at the Mar. 24 offering for $21 a share. He still owns it--but it's $12 now. EarthShell declined amid disappointment over its prospects from profiting anytime soon on sandwich containers for McDonald's. Still, Solomon isn't giving up hope. He intends to sell the stock to record a loss for tax purposes, but plans to repurchase it 31 days later.STOCK-PICKER. Just because an IPO has plunged doesn't mean it's a screaming bargain. Robert Natale, co-manager of the Bear Stearns S&P Stars Fund, has studied the new-issues market carefully and found that the worst-performing new issues usually continue to underperform. "You really need to be a stock-picker to do this," he warns. "Throwing darts won't work."

To see if we could zero in on some discounted IPOs with potential, we turned to Standard & Poor's (like BUSINESS WEEK, a unit of The McGraw-Hill Companies) to review last year's 374 new stock issues. From there, we winnowed out smaller stocks that went public at prices lower than $10, along with any that now trade at less than $5. We excluded cheaper IPOs because they tend to be underwritten by smaller investment banks and don't generate much of a following among investors and analysts. We also excluded stocks that weren't trading at least 10% below their initial offering prices.

That left us with 51 issues. We poured those into Morningstar's StockTools software to screen for companies with market values of at least $100 million and which analysts expect to report a profit next year. Only four companies made the cut (table): Box Hill Systems, Children's Place Retail Stores, Positron Fiber Systems, and Ramco Energy.STIFF COMPETITION. Are the four worth buying now? Perhaps, but each company suffers from flaws. Box Hill, for instance, must compete against the likes of Compaq Computer, Hewlett-Packard, and Sun Microsystems. On the other hand, its earnings are growing, and it continues to have a wide following on Wall Street, with five analysts covering the stock.

Children's Place, a New Jersey-based retailer of kids' clothing, saw gross margins narrow in the fiscal year ended Jan. 31 as it slashed prices to clear inventories. Reversing that practice as the chain expands will be a key to the stock's revival. In fact, the chain's same-store sales were up 7% in the latest quarter ended May 2, vs. 5% the year before, a sign that the worst may be over.

The news is less encouraging for Positron, a manufacturer of telecom gear in Montreal, which has been suffering from delays in testing and launching a new product. Meanwhile, Ramco Energy, a British developer of oil and gas fields in eastern Europe and the former Soviet Union, suspended its dividend in April.

Analyst Shah is also extremely picky. He has recommended just 61 of the more than 3,900 companies that have gone public since January, 1994. But his firm's recommendations, which have included Estee Lauder and Sabre Group, have racked up an annual average return of 42% through Mar. 31. Right now, Shah counsels shunning biotechnology IPOs: "Virtually every biotech company has disappointed investors."

Just the same, one advantage buyers of discounted IPOs enjoy is that the companies, once they have gone public, are obliged to disclose much more information than they do in their prospectuses. For example, Children's Place must now report its financials at least every quarter, giving investors a window into signs of improvements in the chain.

If digging around Wall Street's castoffs on your own isn't for you, a new mutual fund, IPO Plus Aftermarket, will do the screening for you. Sponsored by Renaissance Capital, the no-load fund (888 476-3863, $2,500 minimum) has climbed 12% since its February debut. It aims to invest in IPOs when they're offered and as values develop later on. The fund's biggest holdings include CB Commercial (the former Coldwell Banker real estate group); mutual-fund distributor Waddell & Reed Financial; multimedia-chip manufacturer NeoMagic; telecom equipment maker RELTEC; and Keebler, the cookie baker best known for its elves.

Whether you go with a fund or purchase stocks directly, bear in mind that this strategy entails "looking for diamonds in the rough--and there are not a lot of them," Bear Stearns's Natale says. "For every Microsoft, there are five other stocks that disappear from the face of the earth." All the more reason to do your homework carefully before you buy what looks at first to be a bargain left behind in the IPO frenzy.Robert BarkerReturn to top

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