IPO – Do’s & Don’ts

by 15 Dec, 2018

If you’re interested in investments or maybe have a friend who slaves his life away at an investment bank, you may have heard the term ‘IPO’ thrown about in conversation. If you’ve never understood what on earth this is, don’t worry because this blog will be your guide to cutting through the jargon and learning how to handle them!

So what is an IPO?

An IPO, or Initial Public Offering to give it’s full name, is when a company issues stock for the first time to the public, offering its shares through a stock exchange.

When a private company wants to expand it can either go to the bank for a loan, raise debt by issuing bonds, or go public in order to raise funds for the next phase of its development. By offering shares to the millions of investors in the public markets, companies can raise money extremely quickly and use it to develop their business further.

As an added bonus, the media often generates significant hype in the markets, growing the brand’s exposure to a wider audience of potential investors for its IPO. Sometimes the demand for a company’s shares can completely outstrip the supply by up to 5 or more times – this is known as being ‘oversubscribed’.

But deciding to go public is not all sunshine and rainbows. As a publicly listed company, it becomes exposed to the full force of regulators, such as the Securities Exchange Commission (SEC), and they’re far from friendly!

Publicly listed companies require far more comprehensive and transparent administration, accounting and financial reporting than private companies. This can be extremely costly, making the decision to go through with an IPO a delicate evaluation of costs and benefits. Even the slightest mismatch in timing or strategy has the potential to make or break a company’s future.

What can I expect?

Because you are a retail investor you cannot expect to get your hands on shares in the pre-IPO ‘grey market’. Pre-IPO shares are reserved specifically for friends, family and private equity or institutional investors (syndicates) with monstrous bank balances, and are sold at a discount to these early investors.

In the IPO preparation process, the investment bank taking the company to market will decide on a price at which the public trading will begin. This is where you come in.

Picking winning stocks based on fundamental features or technical history can be tricky enough, but making an informed decision on a company with neither of these things is even harder!

The fact that IPO’s have very little data to fall back on makes them notoriously difficult to trade as a retail investor. The opening price movements on the first day of an IPO are often large, fast and extremely hard to predict. This makes them attractive to high-risk short-term traders, but not so enticing for long-term investors.  

Depending on the initial opening, prices will either climb or fall rapidly as the shares hit the open market. The early days, or sometimes even months, are often not a fair reflection of the company’s future direction as speculative traders move prices around until they find a stable footing and adjust to public life.

Longer-term investors will often stay out of the first few days of crazy trading and enter once the price has stabilised. The point at which an IPO stabilises is called a ‘base’ and this is what the longer-term investors will look for before analysing the fundamental components of the company in question, and investing.

But what should you be looking for in a good IPO?

What makes a good IPO?

At the end of the day, a successful IPO comes down to prudent business practices, effective management and the global economic environment in which it lands.

Research has shown that over a five year period, IPO’s of smaller companies tend to underperform those of larger companies. So a good place to start is to look at the size of the company and its business model.

Typically, the larger investment banks, such as Goldman Sachs, Morgan Stanley or Merrill Lynch etc. will generate the most sustainable IPO’s as they have the resources and expertise to cover every aspect of the intricate process – but it’s obviously not an exact science.

In terms of a business plan, the company must have a sound product that is likely to be used widely, is on trend and has considerable longevity. Comparing it to similar companies is often a useful measure of an IPO’s chances at success, and understanding the company’s plans for the future will determine how much of the market they could potentially occupy.

Finally, an IPO’s timing is very important. If a tech company, which is very sensitive to the business cycle, goes public during a recession there’s a high chance that its IPO will tank. However, a more defensive consumer staples company might perform extremely well when launched during a recession. So evaluating the company within the context of its current economic environment is also an extremely important component of identifying potential IPO winners and losers.

How should I respond to an IPO?

How you respond ultimately depends on your risk profile and how you like to invest. Investing in the early days of an IPO is a fast-paced high-risk game for investors who favour short time horizons, are extra sure they have a high likelihood of success and can afford to take on the extra risk.

The average long-term investor is better off standing back and watching for a period of time as the markets adjust and receiving confirmation of a base before making an informed decision to invest or not. This approach is far less risky, and better suited to investors seeking value, rather than short-term returns.

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