These are dazzling days for initial public offerings. Netscape Communications Corp.'s stock is hitting the stratosphere. Estee Lauder is up 35% and Gucci 68%. Small investors can profitably invest in IPOs. But if lured by the quick buck, it's easy for them to get sandbagged.
Most individual investors are at the bottom of the money chain. Venture capitalists, entrepreneurs, and other startup investors in a private company do exceptionally well when it goes public. The new-issue price is way above the cost of their equity investments. Around the time of an IPO, Wall Street underwriters (called a syndicate when there is more than one investment bank) like to dole out blocks of stock to large institutional investors and a few favored high-net-worth customers. These preferred investors do well, too. Underwriters typically price a new issue 10% to 15% below what they guesstimate investors are willing to pay in order to ensure a favorable reception.
DON'T OVERPAY. Small investors are usually shut out of the action until trading in the newly public stock begins. But with many IPOs showing their biggest gains during the first few days of trading, it's easy for an investor to overpay, limiting future investment returns. Numerous studies have demonstrated that the average IPO bought at the end of the first day of trading subsequently underperforms the market, according to Jay R. Ritter, finance professor at the University of Illinois at Urbana-Champaign. Says Jeremy Siegal, professor of finance at the Wharton School: "At the offering price, IPOs are good investments. But at the first trade price or in the first few days, they are usually overpriced."
The IPO market is susceptible to infectious waves of investor enthusiasm that can last more than a few days. The 20-year-old biotech industry has made outstanding medical advances and developed impressive products. Investors got carried away with the promise of biotech in the early 1990s, and stock prices surged wildly higher--only to crash in 1993. This tendency toward big price swings can be exacerbated by "momentum" investors, often large mutual funds and sophisticated hedge funds, which skim profits by rapidly shifting money from one high-flying stock to the next.
SIT BACK. Fact is, IPOs are mostly high-risk, high-reward investments. For most investors, the best way to play volatile IPOs is to own a diversified portfolio of newly minted companies, perhaps through small capitalization and emerging-growth equity mutual funds. For individuals who prefer owning individual companies long term, market veterans suggest sitting back for at least a year after an IPO. You can often pick up a good company at a reasonable price once the market gunslingers have moved on. More active traders can sometimes get in on the action after a few weeks. Look at Netscape. It was offered at $28 a share on Aug. 9. It immediately took off, rising as high as $78 that day, only to close at $57. It traded in that range for two months and then started to make its big move to $171 on Dec. 5.
By all means, invest in IPOs--slowly and carefully.