Be wary when jumping into IPO waters

Going for the big score: 2 BYU professors say the average investor is better off with a diversified, established portfolio
This is an archived article that was published on in 2006, and information in the article may be outdated. It is provided only for personal research purposes and may not be reprinted.

IPO tips

l Don't be in a rush to buy an IPO. The vast majority of IPOs decline after their opening day. One example: In 1999, Etoys went public at $76 per share but saw its share price drop to $36 several months later. By the end of the year, it was trading at $25.

l Don't buy a stock just because it is an IPO. Consider whether the company has a product or service that people want or need. Just because a company is going public does not mean that it has a viable product or service to offer.

l Make sure the company has a plan to make money. Many companies lose money for years before they turn a profit. But their business plans should expect profitability in a reasonable amount of time.

l Be patient. If you understand and believe in a company's products, management and strategy, don't get rid of the stock just because its share price is volatile. But do sell if the company's fundamentals have taken a turn for the worse.

More investors than ever are smitten with initial public offerings after watching Google's shares shoot up to the price of gold over the past year.

But should the average investor even be considering getting in on the next hot IPO?

The answer most of the time is no, according to the co-author of a Brigham Young University study of the IPO phenomenon.

"The few IPOs that shoot to the moon have a lot of people licking their chops," said business professor James C. Brau. "There's always a chance that an IPO is going to shoot to the moon, but it's probably not going to. Investors need to understand that, on average, IPOs underperform investments in seasoned, more established companies."

Brau and fellow business professor Stanley E. Fawcett interviewed 336 chief executive officers of companies that have successfully gone public, those that have attempted IPOs but did not complete them and those that have never attempted or completed public offerings. Their study is published in Wednesday's issue of the Journal of Finance.

Brau, an associate professor of finance in the Marriott School of Management, said the average investor will do better sticking with a well-balanced diversified portfolio of stocks and other investments than trying to score big with an IPO.

Brau and Fawcett's findings support a number of other studies of public offerings that conclude that returns on IPO stocks often lag returns of broader stock indexes.

According to stock-research firm Morningstar Inc., a number of factors make IPOs lousy investments. Company executives often sell substantial blocks of shares in the year after an IPO, putting enough shares on the market to depress prices. And companies often have secondary offerings that put even more shares on the market, further depressing prices if there isn't enough demand for shares. And ultimately, once the hype of an IPO ends - in the weeks or months after an offering debuts - shares can slump miserably.

While Brau has studied the returns of IPOs over the long term, the focus of his and Fawcett's research was on why companies go public.

Most business school students learn that companies go public as a cost-effective way to raise the money they need to grow.

But Brau said he and Fawcett discovered that perhaps the biggest reason many companies go public is to facilitate future acquisitions.

Once a company is public, it has easily traded shares that can make it easier to acquire other companies or be acquired. Many companies, he said, like to "buy" growth.

Brau said he and Fawcett found that in many cases, companies that have recently completed an IPO are more likely to acquire other companies than to be acquired themselves.

Whatever the motivation for going public, Salt Lake City investment adviser Sterling Jenson also believes many individual investors should steer clear of IPOs.

"Many investors don't know how to understand and interpret financial statements and they will go into an IPO simply because they got a hot tip," said Jenson, regional managing director for Wells Capital Management, which manages $173 billion for clients nationwide. "They don't understand the risks involved."