The Do’s and Don’ts of IPO Investing

Investors are always itchy to get on board with the hot new tech stock IPO – despite the rcent lackluster performance of some big names . So, how do you know the difference between a bull and a bear on IPO day?

Be Wary of Cash Outs

Some initial public offerings seem more about letting founders and other insiders vash out of their holdings than anything else. There’s one problem with this conspiracy theory, however: Securities and Exchange Commission (SEC) rules dictate that a company’s officers and employees hold their stock for a predetermined period of time known as a “lock-up period.” This is anywhere from 90 days to two years. Still, when doing your homework ask yourself this: Does the company have a sustainable business model that will make stock ownership an attractive option – or is it just trying to cash in on being the fad of the moment?

Watch Out For Irrational Exuberance

Because IPOs are such media-driven events, there’s often an initial period of euphoria before a crash. For example,one electric care company saw a 60 percent increase in the price of its stock during the first hour and a half of trading. When the initial buzz wore off, the stock’s value plummeted 43 percent over the next four days.. A more cautious investor would do well to sit back and see what the stock does for a few days, waiting for a dip, rather than buying at the initial asking price.

Look at the Underwriters

You don’t have a crystal ball to know whether a stock is going to do well. You can, however, look to experts who are intimately involved in the process and keep an eye on what they’re doing. Underwriters work in two ways: “best effort” and “firm commitment.” You’re going to want to buy stocks where the underwriters have made a firm commitment.

This means that, as part of their investment deal, they have to buy a certain amount of stock. They then attempt to resell this stock at something resembling the IPO price. This means their financial welfare is directly tied to the success or failure of the company. When an underwriter invests on a firm commitment basis, you know they have faith in the company.

“Best effort?” Not so much. If a company doesn’t have underwriters with full faith in it, why should you?

Investing In New Companies For The Extra Cautious

Perhaps the most cautious course of action you can take is to wait for the lock-up period to end. Even if the company is sound, with a good business plan and a product or service that people are interested in, the stock’s value might drop sharply after the lock-up period is over. This can be the ideal time to buy, as the excess stocks flood the market and depress the price.

Do Your Research

As with any investment instrument, you need to do your due diligence before you purchase a stock. A company’s prospectus is available for any potential investor to peruse prior to the IPO. In fact, you can find them online on the Securities and Exchange Commission’s website.

Don’t let your desire to get rich quick have you throwing your money down the toilet. Be patient, do research, see what other investors are doing – and then you’ll be better equipped to invest in an IPO.

From mint.com