Few things work investors into a frenzy like the prospect of a company's making its first foray into the stock market. Spectacular initial public offerings such as that of Netscape Communications Corp. have only fed the excitement in the last few years. Shares in the Internet software company had been priced at $28 each for the IPO, but the demand was such that on their first day of trading in 1995, they opened at an incredible $71 before settling down to a still-impressive $58 at the end of the day.
Be aware, though, that most individual investors can't buy IPO shares at their initial prices. For one thing, not all brokerages are allocated shares. The underwriting investment banks' big clients-- such as pension funds, mutual funds, other corporations and high-net-worth individuals--get a first pass at the shares. (If a broker offers you shares of an IPO and you're not a major client, you might want to be a bit skeptical; it may be that the big players don't have much interest, so maybe you shouldn't either.)
There are several reasons Fools should avoid IPOs:
* They're considerably more volatile than other stocks.
* Many are young companies that have yet to prove themselves. Fools prefer to let a company get a few quarters under its belt before we invest.
* IPOs tend to underperform. Finance professors Tim Loughran and Jay R. Ritter examined the performance of 4,753 IPOs between 1970 and 1990. In their second six months on the market, the newissues lost 1.1% on average, compared with a gain of 3.4% on average for other firms of the same size. For the five years after the offering, the average annual return for IPOs was 5.1%, vs. 11.8% for the counterparts.
So if you hear about an IPO, relax. Although many do skyrocket in their first days, many others don't. And even the much-hyped high-fliers often come back to earth, their stock prices brought down by the same reasons any other stock will be.
There are many great companies out there that have been trading for a year or longer; we prefer to dig for our truffles in that field.