Investing in IPOs

Only Dead Fish Go With The Flow

Stock Market Video

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The impending initial public offering, or IPO, for Facebook (FB) was in the news again this week because of a CNBC report on Tuesday that CEO Mark Zuckerberg has been so focused on running the business---he acquired Instagram recently and bought 650 AOL patents from Microsoft (MSFT)--that there's been precisely zero time to prepare for the traditional investor road show. Now, instead of a mid-May offering, the company might start the road show in mid-May. This would place the actual offering either at the end of May or in early June.

I mention this because of the mass amount of hype the Facebook IPO has received since the company announced the offering in early February. I even wrote a column not long after the announcement, wondering if it was a good idea to invest in the company at all.

I'm not planning a re-hash of that topic today, since I still agree with my original opinion. No, what I'm instead curious about is whether it's a good idea to invest in a company's initial public offering whether it's hot or not.

Let me explain. If you purchased $10,000 worth of Microsoft when it went public in 1986, you'd have $29 million today. That's assuming, of course, that you held onto all your stock and just let it ride without making any changes to your position.

Today, we know making that purchase 26 years ago would've been a very profitable move. But for every IPO that eventually makes early investors loads of money like Microsoft, there's at least one more that debuted to loads of fanfare but failed to perform.

Bloomberg last year did a study on the 25 hottest IPOs of 2010 and 2011, and discovered that 20 of them--a full 80%--fell an average of 50% from their offering price (as of November 4, 2011 when Bloomberg released their data). Demand Media (DMD), one of the stocks on the chart, fell a full 68% between its January 28, 2011 IPO and the time of that Bloomberg chart. It closed Thursday at 6.99 (The stock debuted at 20.44).

That IPOs are incredibly risky almost goes without saying, since it's entirely possible that a company which is not well-run will go public during a bull market and have their stock shoot through the roof only to tank in the near term. It's for this reason that purchasing stock in a newly public company at the IPO price isn't always the best thing to do.

And investing in a "hot" IPO is an even worse idea. When popular companies such as Facebook decide to go public, it behooves company management and early investors to convince the market that the company is a good investment. This way, those insiders and early investors can turn a profit from their stake in the company. The people who will become millionaires from the Facebook IPO, for example, are those early investors or employees with a lot of stock options.

For individual investors, it's better to wait a few weeks to see what trading range the company falls into. For a more specific guideline, I'll defer to Mike Cintolo, who wrote in the February 8 issue of Cabot Market Letter that "as with any new issue, we prefer to see some consolidation after the offering, usually for two to five weeks, followed by a push to new highs."

This consolidation followed by a push shows that institutional investors are interested and will protect you from a sharp near-term loss. I'll use Demand Media as an example again. After the IPO at 20.44, the stock went as high as 24.55 on March 4, 2011 before entering a persistent downtrend. It didn't build any sort of base until almost August 2011, when the stock fell to under 10, where it's stayed ever since.

With this high risk attached to investing in a newly public company, it's a fair question to ask if you should bother putting any money into an IPO. And the best way to answer that is to look at the company's fundamentals (assuming you don't want to wait for a consolidation).

If the fundamentals of a company are strong--they're in a market with high barriers to entry, have a revolutionary product or service and show strong sales and earnings growth--then the company might be a good investment. Still, when you invest without the benefit of a healthy chart--and in particular evidence that institutions are supporting the stock--your risks are increased. In such cases, I suggest keeping your position small, since that will leave you able to let the position ride without worrying about losing too much money.

Those are my thoughts, and if you disagree I'd love to hear it. Simply reply to this email and let me know what you think about this or any other topic.



Here's this week's Contrary Opinion Button. Remember, you can always view all of the buttons by clicking here.

Only Dead Fish Go With The Flow

This thought is rooted in religion; when The Right Reverend Robert Daly in 1826 said, "live fish swim against the stream, while dead ones float with it," the sentiment was already a classic. In the 20th century, Malcolm Muggeridge was notable for commenting, "Never forget that only dead fish swim with the stream." Going with the flow is a far more recent coinage. In any case, it reminds us that to be a successful investor, you can't just float along; you've got to do the work. And to be a contrarian investor, you've got to do the uncomfortable thinking that leads you to swim against the flow of popular opinion.

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In this week's Stock Market Video, Cabot Market Letter and Cabot Top Ten Trader Editor Mike Cintolo says that after a rough start to the week, the market and leading stocks have bounced back nicely. Stocks discussed: PulteGroup (PHM), Ryland Group (RYL), Lennar (LEN), Continental Resources (CLR), Pioneer Natural Resources (PXD), CF Industries (CF), GNC Holdings (GNC), Dunkin Brands (DNKN) and LinkedIn (LNKD). Click below to watch the video!

In case you didn't get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, there are links below to each issue.

Cabot Wealth Advisory 4/23/12 - Three Factors Determine if You Make Money in the Market

On Monday, Cabot Options Trader editor Rick Pendergraft examined the three factors that will determine whether or not you make money in the market--average win, average loss and winning percentage. Rick also discussed three scenarios to illustrate how important these factors are.

Cabot Wealth Advisory 4/26/12 - Finding Bargains in Value Stocks

On Thursday, Cabot Benjamin Graham Value Letter editor Roy Ward wrote about how to use company balance sheets to determine the true value of a stock. This included a lesson about finding the price/book value per share ratio and its importance to value stocks. Featured stocks: Fred's Inc. 'A' (FRED) and Ingles Markets (IMKTA).

Happy Investing,

Matt Delman
Editor, Cabot Wealth Advisory

Editor's Note: Do you get whiplash from uptrends and downtrends? Want a system with clear signals on what to buy and when? Then click here to learn more.