An initial public offering (IPO) of a company’s stock is a very special time. Most investors perceive an IPO as a tremendous opportunity to get in “on the ground floor” and make a considerable amount of money. However, they may fail to realize that it is at that extraordinary moment that they are at greatest peril and should be most cautious.
A number of very high profile IPOs have recently come to market. Twitter went public last week to much fanfare, and the price of its shares almost doubled on the first day of trading. Before that were IPOs from Groupon, and Zynga. And of course, in May 2012, Facebook floated the granddaddy of recent IPOs.
How should a rational investor think about this terribly exciting, and much hyped, process by which prominent private companies “go public?” Here is some food for thought:
The absence of market mechanisms
The pricing an IPO occurs before the new stock starts trading publicly. As a result, it is less subject to the market forces that usually keep investors (somewhat) protected from overpaying. As I have urged in the past, investment vehicles that are not trading on public markets are vulnerable to price manipulation. One of an investor’s prime defenses – the workings of a properly functioning and highly liquid market – gets stripped away. The result is a greatly increased likelihood of being hoodwinked.
So many IPOs seem to shoot up on their first day of trading, though, that the idea of participating is almost irresistible. For an interesting compilation of data on IPO issuance, see here.
Somebody is getting ripped off
Consider that Wall Street’s job, at least in theory, is to price a new offering correctly. If the price is deliberately set too low, they are stealing from the company’s owners. But see this article for a counter argument about the value of the hype to the issuing company.
The matter of correct pricing changes, though, when the shares start trading on a highly liquid exchange. At that point, the public takes over and more reliable market mechanisms come into play.
You are unlikely to get any
Let’s assume, though, that an investor is not troubled by the manipulative practice of deliberate under-pricing. Notwithstanding that unfairness may be perpetrated against the owners of the company, there is money to be made. All one need do is be among the lucky few who get assigned shares prior to trading. Of course, this is not easily accomplished since this source of “free money” is carefully doled out to the very best customers. Indeed, you are very unlikely to participate in any meaningful way.
You are taking the opposite bet from the owners of the company
You may not know everything about the company coming to market. Some information about the firm and its prospects, promises, and challenges lies hidden from your view. Who knows the most about this company? The owners. And they are best positioned to make educated guesses about its future and its proper pricing.
In this case, though, you are taking the opposite side of the bet from those very same owners. At the time of an IPO, they are selling part of the company. You are buying. It may be disconcerting to realize that at the moment they wish to have less ownership, you are seeking to jump aboard the ship.
None of this is to say that buying stock in a newly public company is always folly. Rather, the point being made is that the period around an IPO is highly susceptible to manipulation and undue influence by various parties. The process is fraught with opportunities for insiders to take advantage of those with less information. The intelligent investor should think hard about who suffers that information deficiency. “Ask not for whom the bell tolls…”