How to Invest in IPO Stocks

Investing in any stock can be a maddening experience, especially for beginners. You click “buy” and you watch your brokerage statement. You’re gleeful when your stock goes up and disappointed when it goes down.

When it comes to investing in IPO stocks — or companies that have recently held their initial public offering and can be traded on the markets for the first time — take that experience and multiply it by 1,000! It can be so disorienting that it’s difficult to tell up from down.

That’s because newly public stocks can be incredibly volatile. They can move up by 10% or more one day and down by an equal amount the next. We’ll get into why that’s the case below — but it can be a harrowing experience…

In 2012, Fool Eric Bleeker wrote about a person who emailed him about investing her entire life savings — $40,000 originally slated for a down payment on a house — in Facebook’s IPO in May 2012. His verdict on the move: “That’s insane.”

He’s not wrong. Investing your entire life savings in a single IPO is not rational or smart. But at the time, Eric’s article was prescient. Shares of Facebook fell 53% by September 2012, and the investor had lost half her life savings.

A modern-day tragedy, right?

Well, the thing about the stock market is that — until you sell your shares — there’s always tomorrow. Over the next six years, shares jumped 1,130%! That investment — worth just $19,000 in September 2012 — clocked in at more than $230,000 by July 2018. Forget a down payment; that optimistic investor could now pay for the whole house!

A modern-day success story, right?

Hopefully, this helps you see that when we talk about “how” to invest in IPO stocks, “with caution” and “with eyes wide open” are the best answers.

What is an IPO?

The easiest way to understand an IPO is to highlight an imaginary company trying to make a new machine. Let’s pretend this new machine is a teleportation device. Obviously, it’s a very exciting development.

The woman who came up with the technology for the device had been testing it in a university lab for years. When she finally thought she’d perfected it, she decided it was time to bring it to the masses. But the road to that goal was long and winding.

In general, the process went like this:

  • She secured her patents to protect the intellectual property.
  • She presented her idea to trusted friends with ties to the business community.
  • Through these ties, she found the first employees of her teleportation company — a new CEO, CFO, and COO. She would function as the chief technology officer.
  • The company got an official moniker: Star Trek Enterprise.
  • This team of four then went to venture capital (VC) funds all over the world. They asked for money to manufacture and test large teleportation devices. (It’s an expensive process.) In return for the money, they gave these VCs ownership of a modest percentage of Star Trek Enterprise.
  • Over time, Star Trek Enterprise grew. It expanded to 100 employees and developed its first marketable teleportation device. During that time, there were other rounds of fundraising to help make ends meet, while Star Trek Enterprise had yet to make a single sale.
  • The first teleportation device was a huge hit — it allowed small packages to be delivered right to your house instantly. They have been selling like hotcakes.

Now that Star Trek Enterprise is a smash hit, it prepares for an IPO. The company works with a bank to offer shares on the New York Stock Exchange under the ticker BEAM. The process can be prolonged. The bank and the company often go on an “IPO roadshow” to tout the soon-to-be-available stock. After talking with potential investors, the bank and Star Trek Enterprise determine a valuation and the number of shares to issue.

And they aren’t limited to listing on the New York Stock Exchange. Nasdaq is the other popular option in the U.S. If the company chooses to, it could also list its shares abroad, like on Shanghai or Hong Kong Stock Exchange, or — closer to home — on the Toronto Stock Exchange.

When the IPO eventually arrives, management usually appears on the floor of the stock exchange and rings the opening bell. Because the roadshow has built up the requisite excitement, there’s usually strong demand for shares, which can send them soaring within hours. Anyone with a brokerage account can buy a share of BEAM and own a part of it. But usually, it’s better to wait. We’ll explain why below.

Why do companies go public?

There are three big reasons companies decide to go public.

  1. The first is a matter of prestige. Over the decades, taking your company public is a signal to the business world that you’ve “made it.” It is a badge of honor akin to winning a Nobel or graduating as the valedictorian.
  2. The second is a matter of rewarding those who helped you early on. Those VC funds that poured money into Star Trek Enterprise weren’t totally altruistic. They want to see nice returns on their investment. The problem is that when a company is privately held, it’s very difficult to find a buyer and determine a price at which to sell your stake. When a company goes public, those early investors have a chance to finally cash in. Their initial investment in the company is converted into shares, and those shares can then be sold on the open market.
  3. The third is a simple matter of funding. By offering shares on the public market, companies gain access to instant, non-debt-related capital. The private markets have changed considerably over the past 20 years — with tons of VC capital being available to privately held companies. This was unthinkable in years past.

But even today, there are companies that need access to that capital, like Tesla(NASDAQ:TSLA), which makes electric vehicles. It costs tens of billions of dollars to build gigafactories and manufacture cars of the future. Without the ability to conduct secondary offerings (in which a company issues new shares after already being public), such companies would be forced to take on debt.

By avoiding debt, the company chooses to dilute existing shareholders — there are more shares for the same underlying company, meaning you own less of it. But that seems more prudent, as taking on lots of debt can make a company fragile and force it to spend an outsized portion of cash on debt interest in the future.

Why are IPO stocks so volatile?

The late Benjamin Graham, known as the Father of Value Investing, wrote about stocks in the 1930s in the shadow of the Great Depression. At the time, most Americans didn’t understand the stock market, believing it to be nothing more than a rigged gambling machine to benefit Wall Street.

Not so, thought Graham. Yes, an enormous stock market crash kicked off the Great Depression. And sure, daily movements in the stock market seem to happen for no reason whatsoever. But the key is to change the timeline upon which you view such moves. Graham said:

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

What does this mean exactly? Over the short term, a stock’s movement has a lot to do with fickle things like investor attitudes and popularity. There’s a limited number of shares of a company available. If everyone wants a piece of a company, the demand for those shares drives up the price.

This explains why IPO stocks pop, or go way up in value, on their first day. Pent-up demand to own a slice of a company leads shares to skyrocket. Beyond Meat (NASDAQ:BYND) is the perfect example. The company has 46 million shares total, but it only offered 9.6 million in its IPO. In other words, only 20% of the company was available to the public.

Limited supply and huge demand caused the stock to quadruple in price before the company ever released a quarterly report. Think about that: There was no new information for the public that wasn’t in the prospectus (the really long document the company provided to investors before going public). And yet shares increased 300% in little more than a month! That’s what a voting machine looks like.

But over time, supply and demand will even out. Those investors excited about the vegan craze will move on to something else — or new vegan-focused companies that hit the market, thus cannibalizing interest in Beyond Meat. That doesn’t mean shares will tank when that happens. Instead, it just means the company’s stock will trade based on business results rather than FOMO (fear of missing out) on the next big stock.

Can I buy pre-IPO shares, or do I have to wait until the first day of trading?

It’s not usually possible for individual investors like you and me to buy shares at their initial offering price. When a company goes public, it works with investment bankers to take care of the details. Those bankers buy up shares. Sometimes, the shares are offered to the bank’s top-tier clients at a cheaper price than what’s offered to the public. Because IPO stocks often experience a huge pop on the first day, these clients earn quick and easy returns — making them more loyal to that bank.

One exception to the rule is…

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