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IPOs: Land of opportunity or risky wager?

Initial public offerings can be enticing, but take care and do your research.

  • Fidelity Active Trader News
  • – 01/15/2014
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From microblogging social media company Twitter (TWTR) and animal health care provider Zoetis (ZTS), to the world’s largest hotel operator Hilton Worldwide (HLT) and oil and gas distributor Plains GP Holdings (PAGP), 2013 was another big year for initial public offerings (IPOs). During 2013, 222 companies went public as a healthy climate for stocks helped these companies raise $55 billion.1

Looking ahead in 2014, there are a number of highly anticipated potential IPOs. This includes mobile payment company Square, online file storage firm Dropbox, and group discount provider LivingSocial.2 Perhaps you’ve heard of these companies. Maybe you’ve even gotten the itch to invest in one of them.

Even though, for the most part, tech has dominated the IPO headlines in recent years, Allie Young, a syndicate trader with Fidelity, thinks there could be a wide array of opportunities in the IPO space. “In the U.S., we expect to see a continually robust IPO market, with activity at levels similar to last year, across a diverse mix of sectors and industries,” Young says.

But beware: IPO investing can be complex, and may be suitable only for experienced investors. If you are interested in investing in an IPO, here are some tips to consider.

Exercise extreme caution

One look at the performance of some of the best performing stocks on the day they went public during 2013, like food retailer Sprouts Farmer’s Market (SFM) and sandwich chain Potbelly (PBPB), would make it seem like there are opportunities to capture profits. Indeed, IPOs averaged a 41% return in 2013.3 The chart below shows the Bloomberg IPO Index making relative highs against the S&P 500, illustrating the outperformance of IPOs compared with the strong broad market last year.

However, the overall track record of IPOs is a far cry from 2013’s exemplary performance. Many companies fail to generate any interest at all on their IPO date, and, unfortunately, investors can be left holding the bag.

Additionally, the stock of an IPO can be extremely volatile in its first few months, not to mention the heightened volatility that can occur on the first day of trading on an exchange. For instance, shares of online professional networking site LinkedIn (LNKD) more than doubled on its IPO date in May 2011, while Australian road building venture BrisConnections dropped 60% on its IPO date in July 2008.

Believe the hype?

Approaching IPO investing with caution may be a smart move because of the potential to get caught up in the exuberance that can surround a new, exciting company opening up its stock to the public. The reality is that for every AT&T (T), Google (GOOG), and Visa (V)—companies that had successful IPOs and are now entrenched leaders in their respective industries—there is a long history of initial public offerings that have not performed well.

Moreover, extracting value out of even successful IPOs can be tricky, from a retail investor’s perspective. For example, suppose you identify an attractive long-term IPO investing candidate that is priced at $20 per share on the IPO date. If you were to buy the shares at around this price, and by the end of the IPO period the stock price had doubled, you might think, “I’ve hit the jackpot!”

But take a step back. This means that the company and its underwriters (a financial group, typically a bank, that is responsible for determining the market price of an IPO) underestimated demand for the company’s stock. Therefore, the company lost out on the opportunity to raise more money to grow its business, because the IPO was mispriced (i.e., instead of receiving $40 a share from the public, it will have received only $20 a share).

In this scenario, if you were looking for short-term profits, great. If not, then a mispriced IPO may not be in the best interests of longer-term investors.

Do your homework

All too often, investors get caught up in IPO hype, rather than considering the opportunity within the constraints of their own unique goals and risk tolerance. The “everyone is doing it” mentality, which was palpably present during the IPOs of Facebook (FB) and other recent, trendy tech companies, should not be why you consider investing in an IPO.

Like any other investment, before making any decision regarding an IPO, you should review your investment goals and conduct a thorough analysis of the company, along with its growth prospects. “Each IPO is unique and needs to be evaluated independently to determine its investment potential,” Young says.

Unfortunately, unlike stocks that are already public, there are distinctive risks to investing in IPOs, and perhaps even more things to be aware of if you are trying to make a tactical trade of an IPO.

One of the primary difficulties that retail investors face when it comes to researching companies that are not public yet is access to information. Publicly traded companies in the U.S., for example, are required by the Securities and Exchange Commission to disseminate financial information quarterly. Private companies are not required to do the same. Consequently, for the individual investor who does not have access to this information, it can be hard to fully assess the company’s merits as a sound investment.

A solution to the retail investor’s IPO quandary

One way that you might be able to navigate the intricate IPO waters is to consider investing with a fund or manager who has the resources to obtain the necessary research needed to do a thorough analysis.

“At Fidelity, for example, our global analysts, portfolio managers, and traders partner with each other to identify and evaluate opportunities in the IPO space where both valuation and the risk-reward profile are attractive,” Young notes. “We work closely with both internal and street resources to understand all facets of the company under assessment, along with the dynamics of the specific IPO, and only invest when we believe both current valuation and long-term total returns are attractive.”

Fidelity brings you access to IPOs

Fidelity investors can sign up to participate in an upcoming IPO (login required). Current offerings on the calendar include American Capital, EP Energy, and Santander Consumer.

This is not to say that it's impossible for individual investors to do the same. However, large investors like Fidelity have the research capabilities and resources needed to invest in the pre-IPO stage, which most individual investors are not able to do.

Also, Fidelity offers retail investors access to certain IPOs.

As for which areas Young is closely watching in 2014: “We expect to see a continued focus on high growth sectors—such as health care, technology, and consumer—which may coincide with many investors’ perception of the IPO market as a source of alpha generation.”

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Views and opinions expressed may not necessarily reflect those of Fidelity Investments. These comments should not be viewed as a recommendation for or against any particular security or trading strategy. Views and opinions are subject to change at any time based on market and other conditions.
1. Source: Renaissance Capital.
2. Some of Fidelity’s funds own a stake in Dropbox.
3. See note 1.
Past performance is no guarantee of future results.
There are risks associated with investing in a public offering, including unproven management, and established companies that may have substantial debt. As such, they may not be appropriate for every investor. Customers should read the offering prospectus carefully, and make their own determination of whether an investment in the offering is consistent with their investment objectives, financial situation, and risk tolerance.
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