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Is the IPO Rollercoaster Worth the Ride?

Is the IPO Rollercoaster Worth the Ride?

On a rollercoaster, there’s nothing like the thrill of anticipation as you roll up the tracks, ever upward, higher and higher. Once you’ve reached the top, take a deep breath to prepare for what is to follow. Then, in the blink of an eye, you are suddenly racing to the bottom, the wind in your hair, the screams piercing your ears, the fear and excitement are undeniable. It’s just a ride, you tell yourself…and before you know it, you are pulling to a stop and with a smile of relief on your face, you realize just how much fun it really was.

Not so with an IPO.

While many aspects of an IPO are often like a rollercoaster, the difference is your money is at stake which makes racing to the bottom far less enjoyable. So why get on the ride in the first place? How do IPOs work? Why are IPOs like a rollercoaster ride? All of these are good questions and you really should know the answers before you invest in them.

An IPO, or initial public offering, is when a private company goes “public”, which means that shares of stock in the company are available for purchase to the investing public in order to raise capital, increase public exposure, as well as a host of other reasons. It’s the premiere of a company on the investment world stage via one of the stock exchanges on Wall Street. Making the decision to take this step is a very complicated and expensive process which ultimately gives the overwhelming advantage, and risk, to the investment bank and underwriters involved. The system, by design, basically leaves the retail investor out of the loop…until the stock hits the open market. But what goes on before that very moment that you can buy in?

After a mountain of paperwork to meet SEC requirements, the company finds an investment bank that will not only underwrite the offering, but ultimately be authorized to sell the stock when the time comes. The offering is made available to institutional investors and large retail clients of the underwriters first. This is done with a red herring prospectus that spells out many of the basics of the offering. It’s preliminary in nature and the shares are not for sale at that time, but brokers can take “indications of interest” from their preferred clients which are later converted into stock orders at the launch.

Among their other responsibilities, the underwriters also determine the stock sale price, making sure that the stock price is not underpriced or overpriced by too much. The opening price per share can either make or break the success of the IPO.

Once all the behind the scenes work is completed and the IPO is in compliance with all SEC requirements, the date is set and anticipation begins to build. Even though IPOs occur with some regularity without any fanfare, there are always a few that are highly publicized and coveted, such as the recent Facebook, Ebay and Google IPOs that provided ticket holders with the wildest ride of all.

Now, the debut of some IPOs can start soaring and then continue to soar even higher. If you happen to invest in a company stock like that, your ride can certainly be the thrill of a lifetime, but for most retail investors, investing in IPOs can be a very bumpy and scary ride. So, when you hit the “buy” button on your trading account seconds after the stock hits the open market, you have just gotten on that rollercoaster. Be ready to ride.

The debut of the IPO stock for Facebook quickly climbed from the initial price of $38 to $45. If you had purchased this from the onset, it was a thrilling climb until the institutional buyers began to quickly sell for maximum profits. Then the stock dropped as low as $25, just like a rollercoaster ride. This particular part of the ride is called Flipping, which is the sale of a hot IPO in a very short time for a quick profit. It’s pretty predictable in a situation like this except to inexperienced retail investors who don’t understand how an IPO works. Almost two months later, Facebook stock was still hovering around $31 or so, well below the initial offering price. However, if you bought it when it hit bottom at $25 after the flipping occurred, you still made a profit.

The price could also drop in a short span of time due to a lock-up period which is a period of time when key players (company officials and employees) are legally bound to hold on to their shares and are not permitted to sell them. That period of time ranges from 3-24 months, with 90 days being the legal minimum as per the SEC. At the end of that time period, and it differs by company, there is often a flood of shares being sold by those key players. This produces a downward effect on the price of the stock.

Another relatively unknown aspect of an IPO debut is the Quiet Period. For 40 days after the IPO’s public debut, all those involved from underwriters to insiders, are restricted from distributing any statements, earnings forecasts or reports for the company. Only after this period does information become available to the public. Hopefully by that point the stock price will have stabilized but watch for movement in the stock as a result of any news, statements or other information that may be released after that 40 day period. As an informed retail investor, you can be ready to respond accordingly.

When you are purchasing any type of security, it is important to research that company. Analyzing stocks, even with a good company history, can sometimes be difficult. An IPO is even more challenging. The historical data and performance that you can research for stocks isn’t available, which puts you at a slight disadvantage as an investor. It’s important to remember that the opportunity to invest will be there after the hype, after the rollercoaster ride, so once there is historical data to review and you can analyze it objectively as an investment, you can make a sound decision.

With that being said, if you are open to the risk of the exciting rollercoaster ride and have some discretionary funds to buy a ticket, there is money to be made if you understand the risk and nuances of IPOs. For those who are a little more cautious, there are mutual funds that solely focus on IPO’s. Let the mutual fund managers use their expertise to get you in and get you out. If you are the kind of retail investor who wants to do it yourself, then exercise caution, don’t get greedy and recognize when the tide is turning. Be ready for large investors flipping, for the lock-up period to end and the quiet period to give way to news and information that will also influence the price. Put in your limit orders and when you have made a nice profit, take it.

While Facebook’s IPO may have been lackluster at best, consider that of LinkedIn. The initial public offering price was $45. It shot up to $90 and then still further to $122 in that same trading session, finally settling at about $94. In that one session, it was up 109%. As of mid-July 2012, a little over a year later, it was around $103. But in November of 2011 thru around January 2012, the stock took quite a dip to about $60 before climbing back up. So this volatile stock had a rollercoaster ride of its own that stretched out over a longer period of time. But selling at the high and rebuying on the dip would have provided another opportunity to profit.

Those two peaks have a nice spread from the low to the high. Now that’s a ride that turned out well for the retail investors who did it right and understood the rules.

What does it mean for you? Investing has a very real risk versus reward component to it. With IPOs, in particular, both the risk and reward possibilities are higher than the average stock transaction. It’s not for every investor. However, for those willing to board the rollercoaster of an IPO, the ride will certainly be exciting. Whether you finish the ride with a profit or a loss is a risk only you can decide to take.

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