4 Valuable Lessons for Investing in IPOs

After its stock launched with a bang on November 4, shares of Groupon (symbol GRPN) have done nothing but slide, following a pattern of recent "hot" initial public offerings. Taken together, they provide lessons to anyone tempted by the IPO market.

Lesson #1: Don’t buy during the first-day feeding frenzy.

Groupon shares soared from their $20 offering price to more than $31 in the first few hours of trading. But before the day was through, the stock settled back to just over $26. On Thursday, November 10, the company’s shares closed at $24.41 -- some 22% below the opening-day high.

IPOs, as a rule, mainly benefit company insiders and big clients of the brokerage firms that sell the shares. Big clients get in at the offering price -- an opportunity usually not available to small investors -- and insiders generally pay a fraction of the offering price for their shares. Individuals who buy on the first day generally pay inflated prices because they’re buying when demand is the greatest. Often they watch their share prices fall back to earth in the following days.

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Keep this in mind when tempted by upcoming IPOs for similar companies, including online rating service Angie’s List, social media phenom Facebook, gaming giant Zynga, and online rating service Yelp.

For example, when LinkedIn went public a few months ago, its stock price followed a Groupon trajectory, only bigger. The offering price was $45; shares opened at $83, then soared to $123 the first day. But now, less than six months later, the shares are selling for $77, some 37% below the high.

Lesson #2: Beware stock offerings with limited shares.

Analysts speculated that one of the reasons Groupon’s stock soared so fast and furiously -- despite what many experts consider a weak business model -- was because so few shares were offered. The company sold just 35 million shares, about 5% of the stock. LinkedIn did much the same.

But scarcity fuels the stock price for only as long as the shares remain scarce. When LinkedIn announced that it would release another $500 million in stock through a secondary offering in early November, the shares started to slide and have been sliding ever since. The company filed the paperwork to issue additional shares on November 3. The previous day, its stock was selling for as much as $91. On November 4, the stock closed at $82.37. It dropped to $80.18 on the 7th, to $78.70 on the 8th and to $75.82 on the 9th.

Lesson #3: Watch the fundamentals.

Pandora Media, like Groupon, was posting huge losses but went public in June on the strength of rapid growth in listeners and revenue. But when the company reported a loss of $3.2 million for the quarter that ended July 31 (bringing first-half losses to $12.3 million), investors cooled to the stock, which is now selling for just $15 -- 6% less than its offering price and 42% less than the first-day high.

Fledgling companies, such as Groupon, that don’t post profits or at least show progress in limiting losses may have to borrow money or issue more shares. Often neither option is good for shareholders.

Of course, investors are willing to tolerate losses for a while, particularly when they think a company just needs a little time to turn the corner, says Nathan White, chief investment officer at Paragon Wealth Management, in Provo, Utah. But that tolerance is likely to last only as long as investors can see clear prospects for profits. “Promise is great,” he says. “But at some point, you’ve got to deliver.”

Lesson #4: Wait for opportunities.

As recent IPO offerings show, share prices often fall dramatically in the months after first-day frenzies. That’s the time to consider getting in, says Lee Simmons, an IPO expert with Hoover’s. “Let the stock settle for a few months and you’ll have the opportunity to buy at a better price.”

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