“Please read the red herring prospectus before investing”. Does something pop up in your mind when you hear this phrase. If you are a seasoned investor you already know that some company is going public. Soon this company will be all over, be it newspapers, TV commercials, business channels, hoardings etc. Going public means a privately held company is selling shares for the first time to public through Initial Public Offering (IPO).

It’s quite possible that we have never heard of this company before. What an individual investor, who stands last in the queue, should do in such situation? How to evaluate if the IPO presents an investing opportunity or it will be a disaster? Approximately eight out of ten IPO’s dooms bereaving investors of their hard earned money. In this article we will try to learn the basics of IPO investing from retail investor perspective so that we can invest in winners in future.

 

What are IPO’s?

Whenever a privately held company plans to raise capital by selling its stocks for the first time to general public it does it through Initial Public Offering. Company hires an investment banker who does the underwriting of the offering and decides the price of shares based on valuation and future growth prospects. These shares are then sold to general public and institutional investors and shares starts trading on stock exchanges.

 

Why so much price fluctuation after listing

As the price of the offering is not decided by the market but an investment banker (a small group of analysts), there are often valuation mismatches because of various reasons such as biased opinion, lack of proper research etc. Once the share starts trading actual price discovery takes place because of participation of the whole lot of investors and if there is a huge mismatch between value and price we witness great price fluctuations exposing retail investors to great risk.

 

Rationale for investing in IPO

As the price fluctuation is discomforting in the beginning, it’s a risky investment option. Analysis of historical data intensifies the pain as most of the IPO’s fail to live up to expectation. So isn’t it wise to keep safe distance from IPO’s? Answer is both yes and no. Answer is yes if you are a believer of research and don’t simply take investment decisions on somebody else’s opinion. If you are ready to take calculated risk you might be rewarded like anything as there are still 2 winners out of 10 and yes normally the winners give tremendous returns. So it’s advisable not to simply shut your eyes towards IPO investing but take an informed decision.

 

How to pick the best one of the lot

Before taking an investment decision, do your own research as there are a number of indicators which can give you an excellent insight weather to take an exposure or not. Here are few points which should be kept in mind before investing –

  1. Invest in Large IPO’s – Large IPO’s are professionally managed and they are high profile event which draws a lot of institutional investor’s attention. Keep a close look on the figures of oversubscription and institutional fund manager’s participation. An oversubscription shows confidence in the business model.
  2. Invest in small IPO’s only if the company deals in sectors whose growth prospects are intact like telecommunication, technology etc. It’s advisable to cross verify the potential of company management and check if company has one or two blockbuster products in its portfolio or not.
  3. Another strategy is investing based on credentials of the underwriter. IPO deals from Goldman Sachs, Merrill Lynch, and Morgan Stanley belong near the top of the list.
  4. Avoid offerings underwritten by small underwriters as they are not focused on due diligence and research.

 

When to get out – Short term View or Long term View

If you are a short term investor you should get out on the listing day itself if the price movements are favorable. Normally prices starts to cool off from second day onwards as initial frenzy is gone.

If you are a long term investor and you believe in the business model of the company you should hold on to your investment and not get swayed away by initial price movements.

 

What If you didn’t get it?

If you didn’t get the shares in the offering you should wait for the right time and not buy the stock at unreasonable price, as underwriters are initially allowed to support the stock price. If you are patient you will get a chance to enter the stock at fair value.

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