Why You Should Stay Away From “Hot” IPOs…
A couple of years ago, a friend texted me, asking my opinion of the upcoming IPO of the ride-hailing company Lyft (Nasdaq: LYFT).
“I wanna go big with it,” he said.
I cringed, knowing that regardless of what I had to say he was going to invest in it anyway. Even if I told him it was unwise.
You see, too many investors think chasing the next hot IPO is a surefire way to get rich. They believe that by buying shares as soon as it goes public, they’re getting in on a “sure thing” before the rest of the crowd.
Unfortunately, that’s far from the truth. The fact is that most of the money has already been made by the time a company goes public.
Let me explain…
Most IPOs Drift Lower Once The Magic Fades…
You see the headlines all the time. A “unicorn” tech firms Uber (NYSE: UBER), Lyft (Nasdaq: LYFT), or Snowflake (NYSE: SNOW) is going public. You’re told that it’s “a big deal”.
While that may be true, you’re better off sitting on the sidelines.
The reason I don’t jump at IPOs is simple. Sure, you might see XYZ company surge on its debut, but that doesn’t typically translate into profits for the average retail investor like you and me.
The truth is that by the time we can get in on the hot IPO, the game is over. Once the glow of the stock’s IPO wears off, shares tend to tumble. Just look at what happened with Lyft…
There are a few reasons why you’ll often end up seeing a chart like this after a “hot” IPO finally hits the market.
One of them is that they hype surrounding it tends to wear off and shares naturally drift lower.
The other has to do with how these deals typically come to market in the first place…
The Mechanics Of IPOs
Most entities looking to go public bring in the big investment banks as underwriters to help navigate the company through the entire process. They charge fat fees for this, naturally.
The underwriters help form the preliminary prospectus, often referred to as the “red herring.” This outlines the company’s financials, use of proceeds, vision and market research, among other things, to present to potential investors. (I always found it humorous that it was called a “red herring,” because the idiom often refers to something that misleads or distracts from important issues.)
They then use this red herring to generate interest and attract buyers. Most of the time, companies will do what is called a “road show” where they host events to pitch the merits of their company to the big institutional investors: investment banks, private-equity firms, and hedge funds.
In exchange for investing in the company looking to go public, these investors get an equity stake in the company and/or options to purchase shares at a specified price… this all happens before the IPO.
These big-money players then start cashing out when a stock makes its debut.
So let me ask you this simple question… Do you want to take the other side of the trade from the so-called “smart” money?
After all, most of these guys are looking to make a quick buck off of the backs of the public market (that’s you). Sure, they may hold on to some shares for the long haul. But typically you’re looking at an incentive structure that will naturally create short-term selling pressure right off the bat.
Another reason I say away has to do with something called restricted stock units (RSUs).
RSUs are stock options given to company directors and c-suite executives as part of a compensation package. They usually have a vesting period so the employees can’t simply unload all their shares at once. But once those RSUs begin to expire, those folks begin to turn those shares into cash by selling them on the open market. And as these large sell orders come in, it pushes the stock price down over time.
What I’ve just outlined is a common occurrence with IPOs. Institutional investors and corporate insiders like to cash in their big profits at the little guy’s expense.
For these reasons, I like to wait until the dust settles and the RSUs begin vesting before I make a decision to invest in any IPO.
Case in point, my most recent recommendation over at Top Stock Advisor went public earlier this year. I’ve been watching it like a hawk since then, and its first vesting period expired at the end of October.
Of course, the RSUs will continue to expire over the coming months and years. But at this point I’m comfortable recommending shares. For one, the stock spiked and has since retreated to near its IPO level. And two, the stock isn’t trading for sky-high valuations. Three, it’s a dominant player in the mortgage and refinance space.
The point is, by waiting for the right time, I was able to look at this stock with clear eyes. My vision wasn’t muddled by the hype surrounding the stock. And for that reason, my readers and I can go into the position confident that we’ll generate market-beating returns in the months to come.
If you can follow a similar pattern, you’re far less likely to get burned by chasing a “hot” IPO. Sure, you may miss an opportunity here and there. But I can practically guarantee you that you’ll come out ahead in the long run.
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