Wednesday, January 26, 2011

IPOs are for shmucks

While it might seem exciting to get in on the action of a hot IPO or two, it might not make good business sense to do so. When a company has an initial public offering, chances are that the company insiders have made sure that the shares being sold to the public are fully priced (or maybe even overpriced).

Sure, the company insiders might claim that investors are getting a good deal, but think about it, the better the deal that the public gets, the worse the deal for the company insiders.If you owned 100% of a great business, would you sell part of it to someone else at a discount? No way. In fact, you would demand a premium for the stake you're selling. The insiders of a company that has plans to have an initial public offering are in the exact same position.

The best, most successful way to invest is to buy good companies at prices that afford you a healthy margin of safety (the margin of safety concept states that an investor should only invest in a stock if it is trading significantly below intrinsic value. The margin of safety concept was popularized by Benjamin Graham). When investing in stocks through IPOs, it isn't likely that investors will have a margin of safety as those stocks will likely be fully priced or even overpriced at the time. Without a margin of safety, investors will be taking on more risks,and if investors overpaid for a stock, they could experience significant losses for quite a long time.    

People might tell you that taking part in IPOs is an easy way to make money and point to some stocks that have went up over 100 percent or even a few hundred percent in the first few days after their IPOs. Just remember that while a stock can surge after its IPO, the stock's price could also fall after its IPO; taking part in an IPO in the hopes to sell the stock at a profit the day it starts trading is gambling not investing.

The title of this article proclaiming that IPOs are for shmucks is, of course, an overstatement. Just be really careful and thoroughly do your research if you plan to take part in an IPO, and ask yourself this question: If the company insiders who know their company better than most, if not all outsiders decide to sell stock in the company, would they really price the stock for the public's benefit (low price), or price the stock for their own benefit (as high a price as possible).

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.