Saturday 8 September 2012

The Initial Public Offering

I begin the first investment-related post with the Initial Public Offering (“IPO”), as this is usually the starting point for most undergrads just starting out to invest in stocks.

Should investors invest in IPOs? The answer is: Depends. However, IPO should not be the starting point for new investors trying to learn about stock investing. IPO is like a lottery. The investment gain in an IPO depends on the demand for it. When an IPO is over-subscribed, balloting is required. For hot IPOs, the number of shares allocated is small even if you are successful in the ballot. Also, the price of the stock could either be higher or lower than the IPO price upon listing. Hence, the gain in an IPO depends on more luck than skills. Would being able to consistently make a profit in IPOs make one a better investor? Well, it only makes him a lucky investor. Just like being successful in lotteries does not make one a better statistician, being successful in IPOs does not make one a better investor. Furthermore, it might give the new investor a false impression that he is good enough and ready for bigger investments in the larger pool of seasoned stocks. In truth, there is no skills to be learnt from IPOs.

IPOs are also not the same as seasoned stocks because the operating environment and performance of the company usually differ when it is private and when it is listed. As a private company, it usually does not have access to much cash. Hence, profits as a percentage of equity (“return on equity” or “ROE”) is higher and the performance is more sparkling. But upon listing, new stocks are sold to investors to raise cash and this reduces the ROE. Hence, to extrapolate the performance of the company before listing to after listing is dangerous. Past performance is not representative of future performance.

Another reason why IPOs sometimes do not make good investments is because they select the best timing to list so as to get the best price for the IPO. This is usually the time when the profits are good and stock demand is high. However, the economy and public appetite for stocks go through cycles. When the economy is poor and public appetite for stocks wanes, the company’s profits and price usually suffer.

So, should investors always stay away from IPOs? No. It is similar to the situation when there is $10 on the floor. Do you pick it up? Well, look out for any danger, pick it up and quickly run before anybody comes after you.

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