Why you should not rush to buy a IPO on first day | stockbee


Why you should not rush to buy a IPO on first day

Buying IPO in after market on first day is suckers bet. Recently people rushed to buy GM . Here is what happened.

I have detailed how to trade IPO's in the Stockbee IPO Trading Guide. The rush to buy IPO on first day in after market by some retail investor is often a foolish bet. Most of the time the strategy is likely to fail. There is very good reason for that. IPO's are allocated to select few funds and individuals. They waste no time in flipping them and selling them in open market once the IPO opens for trading.

The new issue fizzle is a well known phenomenon. There is substantial and overwhelming evidence that shows that IPO under perform the market both in the short run and long run. This is extensively documented fact but Wall Street underwriters would like you to believe that investing in IPO's is good strategy. After all their business depends on finding bag holders for failed IPO's.

Very few IPO's make it over the long run, most fizzle out. How many IPO's from dot com era have survived. How many IPO's from housing boom era have survived? How many IPO's from the ethanol mania phase have survived.  IPO's are like fads they last for short period of time.

There is a sure shot way to make money on IPO if you can get the shares at offer price. Offer price is the price set by underwriters and issuing company for IPO before it starts trading. Research shows that on an average a IPO is 15% under priced. Research shows that over last 15 years, the share price of a typical  IPO rose 15% on first day of trading from offer pricejcboe.

Flipping an IPO is virtually free money for big institutions, select few wealthy individuals, hedge funds and Wall Street insiders. You need a fat account running in multi millions with leading broker like Goldman Sachs, Merrill Lynch, Morgan Stanley, Credit Suisse etc to be part of this money making racket.

Underwriters of IPO systematically under price IPO to make it easier for them to market the IPO and lower their risk to minimum. Under pricing assures that issue will be fully subscribed and the underwriting firm will not have to support the issue. If issue fails underwriters have capital loss.

In practice what this means is those lucky enough to get IPO shares at offer price quickly sell their holding on first day.This depresses the price post IPO. If you understand this you will understand that in vast majority of cases buying IPO in open market on first day is the most foolish thing you can do (but there was a period when the strategy worked it was during dotc com boom).

Unless the market is in mania stage buying IPO on first trading day has no edge. The typical path most IPO will follow post IPO is slow bleed as the IPO's are passed on from sophisticated investors to unsophisticated bag holders. Hot IPO's where investors think they are sure bets tend to perform the worst after IPO. Remember when CBOE IPO came it was touted as very hot IPO. What happened post IPO?

Wait for an IPO to setup after debut. Let the flipping phase be over and then you can find opportunities in IPO when they breakout after forming a base. GM will set up after few days or weeks and might offer a buy opportunity. But rushing to buy it on first day was not necessary. But marketing hype is hard to resist and people do not want to follow good advice and tested methods. Waiting for setups is hardest thing to do for many people.



Pete said...

Excellent advice on trading new IPOs, thank you.

May I add...I think it's always a good idea to know date of lockup expiration when pre IPO investors are allowed to dump the stock if they wish. It's usually 6 months after initial IPO date and may cause price to spike down. Here's a link that I use: http://ipoportal.edgar-online.com/ipo/ipoOfferings.asp?view=lockup.


B7 said...

Since IPO's are such poor investments (on the first day), wouldn't a good strategy be to short them?

Pradeep Bonde said...

supply for shorting may not be available at those time.