Investing in IPOs Can Be Risky Business

Drooling over the prospect of investing in a "hot" initial public offering of stock, like Facebook, Groupon or Zynga? Brace yourself. The bulk of newly issued shares of the most promising new offerings go to institutions, with the relative handful of shares set aside for individuals "distributed with an eyedropper," says David Menlow, president of IPOfinancial.com, a public-offering research firm. Most investors who want shares in a newly public company are forced to buy in the first-day feeding frenzy, which rarely ends well for investors.

Consider what happened to those rushing for shares in LinkedIn (symbol LNKD) when it went public on May 19. The networking site’s shares opened at nearly double the $45 offering price and soared to more than $122 before finishing the day at $94.25. Today, the shares sell for $93.70 (all prices are as of the July 6 close).

The formula is fairly typical. The average IPO gains 18% on the first day of trading, but then underperforms other small-company stocks over the next three years, according to a study by Jay Ritter, a finance professor at the University of Florida.

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That’s likely because people get caught up in the emotion of buying IPOs rather than paying attention to their price. “Most people buy IPOs like they buy lottery tickets -- they’re hoping for a big win,” says Geoff Considine, principal of Quantext, a research firm headquartered in Boulder, Colo. “There’s the potential for a big gain, but on average, it’s a big loser.”

Does that mean individual investors should steer clear of IPOs? Basically, yes. If they can’t get in on the actual IPO, they’d be wise to buy shares the way they’d buy a Mercedes -- lightly used. “Let the stock cool off for a month or so,” suggests Lee Simmons, industry specialist at Hoover’s Inc., an Austin, Tex., corporate research firm. “A lot of these companies have explosive debuts. But a day or two later, they just tank.” In other words, if you let somebody else drive your IPO off the lot, you miss that day-two period of depreciation and might just score a bargain.

Just one month after LinkedIn’s debut, for instance, the company’s shares were selling for as little as $60 -- half of what investors were paying on that first day -- and roughly 50% less than today’s market price.

Menlow considers the 30 to 45 days after the offering to be something of a sweet spot for buying a young company. The reason: Company officials are in a “quiet period,” unable to promote their businesses, and the company is too new for analysts to have produced research reports that might encourage investors to buy. He thinks any IPO that sells for less than its offering price during that period is worth a second look.

A half-dozen U.S. companies that went public since the beginning of May are in that category. But a closer look at these companies underscores the risks of investing in young operations. Only a handful of them are profitable. And while profits seem to make little difference to IPO performance in the short run, they’re key to successful longer-term performance, according to an analysis done by Christian Chabot, who writes a blog called IPO Dashboards.

There are only two U.S. companies that recently had their initial offerings of stock and are both currently profitable and seemingly bargain-priced -- at least from the standpoint of being below their IPO price. One other profitable, lightly used IPO is selling at just a hair above its offering price. We describe the three companies below. Keep in mind that buying young companies is inherently risky. If you buy any IPO, realize that it’s a bit of a gamble.

Vanguard Health Systems Inc. (VHS)

IPO price: $18

Price as of July 6: $17.11

Vanguard is a Nashville-based health care company that operates 26 acute-care hospitals and outpatient facilities. In the quarter that ended March 31 (Vanguard’s third fiscal quarter), revenues soared 77% from the same period a year earlier, and the company reported a meager profit of $2.8 million, or 5 cents per share. The company, which was founded in 1997, posted a loss of $1 million for the first nine months of its fiscal year. But that was a vast improvement over the nine-month period the prior year, when Vanguard lost some $52 million.

If the company can maintain its fast-paced growth, the stock should be a winner. Vanguard, which went public June 21, is selling for about 342 times estimated earnings of 5 cents a share for the fiscal year that ended June 30. But the stock could overcome that crazy price-earnings ratio if Vanguard’s profits continue to improve at the same pace they have this year.

Boingo Wireless (WIFI)

IPO price: $13.50

Price: as of July 6: $9.36

The Los Angeles-based company, founded in 2001, offers and operates Wi-Fi hotspots in public places, such as airports and shopping malls. Analysts think that Boingo will earn 15 cents per share in 2011 and 28 cents per share in 2012 -- largely because Boingo said so. During the first quarter, Boingo lost $329,000, or 6 cents per share, but when it filed its quarterly report to the Securities and Exchange Commission in early June, it indicated that it is currently profitable.

The company says that demand for wireless technology is exploding, thanks to increasing sales of tablets and smart phones. The bad news: More hotels and retailers, such as Starbucks, are offering free Wi-Fi. If that trend grows, it could eat into Boingo’s subscription revenues, which currently account for about one-third of its business.

Spirit Airlines (SAVE)

IPO price: $12

Price as of July 6: $13.17

This fledgling Florida airline provides low-cost flights primarily between Florida and the Caribbean and Latin America -- areas that have been underserved by the cut-rate flight set. Its stock price slid right after its May 25 IPO, but it has since recovered, selling at just a hair above its offering price. Spirit differentiates itself from the rest of the IPO crowd by being solidly profitable. The company earned $72.5 million, or $2.72 per share, in 2010. That gives it a bargain-basement P/E of 4.8. Southwest Airlines, by comparison, sells for nearly 17 times earnings.

To be sure, airlines face some serious headwinds, with volatile fuel prices and high labor costs. And Spirit has managed to raise consumer hackles by instituting an unusual number of fees -- such as a $5 charge for having your boarding pass printed at the airport, and a $30 to $45 fee for packing a carry-on bag. Of course, Dublin’s low-fare Ryanair, which uses that same charge-for-all-extras model, went public at in 1997 at a split-adjusted price of $3 and now sells for $28.64.

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