7 Tips And 7 Risks For IPOs: Part Two of An Investing Series

With all the upcoming IPOs expected in 2019 from the likes of Levi Strauss, UBER, Palantir, Airbnb, Pinterest, and Postmates, what could investors do to be better prepared whether they have an opportunity to buy at the IPO price, or will consider buying shares in the secondary market.

This is part 2 of a two part series. Please see Part 1 for Steps in the IPO process and 13 Reasons Why IPOs perform poorly long term.

Seven tips for investors on whether to buy at IPO price or in the aftermarket:

What’s in the prospectus

  1. Read and analyze the company’s S-1 registration once it is filed. Be aware that this document may be amended several times before the final IPO pricing with potentially material information.
  2.  Get an understanding of the company, its markets, its near-to-intermediate term plans for market and product expansion.
  3. What is company management experience, their compensation,  their share ownership of the company before and after the expected IPO. How deep is their bench as they grow more significantly. Some of the management have been very young (Alphabet’s founders skateboarded to work, Zuckerberg’s hoodie on the Facebook roadshow) and investors needed to get a reasonable comfortable level and trust in their short years as head of the company.
  4. Lockup provisions of existing shareowners and timing of their expiration must be disclosed to potential investors.
  5.   The current plans for the capital raising associated with the IPO but what about future expansion plans and follow-on offerings which may dilute these shareowners.
  6. Does the share structure reflect a dual ownership where the company’s founder/management retain super voting power of the company at the expense of the new shareowners? This has become more common but there are some institutional investors who have policies against buying  this structure.
  7. The risk factors identified in the prospectus are increasingly comprehensive as the SEC is requiring more disclosure of any potential issues that may arise. These factors will provide you with the possible flags that you should be concerned about regarding  the company. You should also factor in your concerns from your previous experience or what you know about the management from their public comments.

Among the possible concerns that are presented in the “Risk Factors” section: 

  1. Industry issues vary and should be disclosed and understood. Some industries are more capital-intensive, more competitive, subject to more regulation, more people-intensive, exposed to commodity pricing or shortages. This section was particularly important for the telecom sector I covered as an equity analyst. Investors were just becoming familiar with the deregulatory environment for traditional telecom companies. This meant increased competition from smaller companies that were rapidly undergoing the IPO process to raise capital. Many alternative carriers (eg. new wireless companies, cable companies providing telecom services) swarmed the larger existing telecom companies.
  2. Regarding economic issues, some companies may be more exposed to global economic pressures while a few may be more defensive and able to weather recessions better.
  3. Substantial risks to the company’s business model due to changes in technology that may make a certain company’s technology obsolete.
  4. Low barriers to entry from potential competitors plague some existing companies. Think how Amazon has transformed the retail industry and the existing brick and mortar retailers like Macy’s.
  5. Revenue concentration by a small number of customers could make it difficult if the company loses any one of those customers.
  6. The company’s need for high capital investment over the next few year will potentially impact the company’s balance sheet, borrowing needs, earning potential and potentially dilute shareholders.
  7. Management may disclose that their primary focus is on growth and leveraging the market while the “window of opportunity” remains open to the company. Emerging growth companies are letting you realize that losses should be expected or worsen with less emphasis on earnings.

This is certainly not an exhaustive list for what you should read and understand about a company and its fundamentals in the S-1 or hear from companies on their roadshows as they meet with potential investors. It is also a working list of questions or issues you need to understand about any company you are considering when making any stock investment for your own stock portfolio.

Buying at the IPO price if after you read the final version of S-1 and have done your homework:

You’ve done your research!

  • The company has outstanding management and you have comfort that they have a talented team and a good plan you think they can execute.
  • The company’s risk factors are surmountable and the capital raising will enable to company provide investors measurable indicators of the success.
  • The company is well positioned and differentiated in an attractive market and has a solid game plan.
  •  The company’s valuation is rich but is comparable to peer companies in the universe. The company may be priced at a rich valuation, usually a multiple of revenue, or EBITDA which stands for earnings before interest, taxes, depreciation and amortization or a very high price-earnings ratio but is expected to normalize over the next couple of years.

The big question is whether you should buy the stock soon after the company goes public because you are enthused about the company but were not able to buy at the IPO price but you watched as the stock went straight up on the first day. It is also tempting to chase a company you see performing well after IPO but sometimes that is the worst time to buy it.

Generally, I would say exercise an abundance of caution. I don’t want to be cute but what goes up often goes down. There are particular times when you may be able to buy that particular stock in the near-to-intermediate future.

Five possibilities of when you may have an opportunity to buy the targeted shares:

  1. When the company reports its first quarterly results after the IPO, the company may report in line or slightly better than what was forecasted. Investors may have hoped or expected  “a big beat” in results and instead the report is largely in line or may even be a little light because of management distraction by the IPO process. This may depress the stock, making more attractive for you.
  2. The lockup waiting period is usually well known and about to expire and it may put some short term pressure on the shares you want to buy. Sometimes the underwriters and the insiders who own the shares have arranged for an organized sale of those shares and the disruption of the shares may be very temporary but provide you with a chance to buy those shares.
  3. More IPOs will flood the market and some institutional investors may need to shift their stock portfolio around, putting pressure on some of the stocks that recently.came to market. When there is a very active IPO market, as is expected in 2019, it can become a more volatile market. Jim Cramer discusses this here. This digestion period for the new supply can benefit prospective investors looking to make new investments.
  4. For investors seeking to participate in the IPO market, there are opportunities to invest in mutual funds and ETFs that specialize in IPOs. You can read and research here and here.
  5. The market declines on worries over a bunch of factors (eg. trade talks fail, economic woes that have little to do with the company whose shares you wish to buy but it takes all of stocks down with one brush. Sometimes it provides an investor with a chance to buy a stock they were looking to buy and it has declined enough to warrant your attention.

Investors must always do their own research, consult your financial professional and exercise some level of caution based on your risk levels. Have you ever bought a stock at the IPO price? Please share your experience so others can learn more. We would like to hear from you!

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