Getting a piece of the action of a hot IPO can be very difficult. The mechanism of how this works can be somewhat complex, put simply it’s the number that balances supply and demand.


Example:


Company “A” needs to raise money and therefore decides to do this via an IPO. For the founders of “A”, the upside is they become a wealthier company and can use the money to become better and more profitable. The downside is that the founders stake in “A” goes down. How do the founders find a solution for this trade? They calculate the number of new shares of “A” they wish to issue, and the price they set per share they wish to sell.


The founders of “A” evaluate how much of the company they wish to retain and how much they wish to sell off. The company is then advertised and offered to institutional investors via its underwriting bank(s), which then invite the investors to submit requests for how many shares they wish to buy, deemed as pre-IPO stocks. Institutional investors are important clients of the underwriting bank(s), comprising of pension funds, mutual funds, and hedge funds.


Why do these investors get in on the act before the general public? For reasons of stocks price stability which is a general rule of the underwriting bank(s), and of course due to their deep pockets and the capacity to take risk. Analysed practically, these institutional investors as well as the bank(s) are in it to make profit on their investment into “A”, large ones at that, leading some to cash in by selling a portion or all of their shares on the day “A” stocks is offered to the public.


Once the shares portion of “A” have been sold by the underwriters to the institutional investors, “A” goes to market, listed on one of the stocks exchanges. On the morning of the first day of listing, orders start to come in from all over the world, consisting of both retail and other institutional investors who were not offered pre-IPO stocks.


The “Market Maker” which is the bank, will begin to collect the orders and evaluate the inbound numbers and then report the share price in the media. The “Market Maker” will set the opening price, which is selected so that supply and demand are balanced. In practical terms, the opening price that maximises the number of trades based on the orders thus far. The “Market Maker” then freezes the price and blocks further orders; this is generally known as the “discovery” period and generally takes place in less than 30 minutes or in the case of a high profile IPOs where there is greater market anticipation, up to an hour.


The shares are then released to the public, and at the close of business on the first day of trading to the public, company “A” has increased its value exponentially. Of course the founders, staff, institutional and other investors who were lucky enough to be allocated or purchase pre-IPO stocks prior to the public, are now extremely excited and eager to calculate their profits at the point of market close that day, all hoping the share price increased. Should the markets have gone crazy for this stocks, these parties would have enjoyed substantial profitable gains.


Companies that make the most profits are generally the best bet stocks to buy as they are superior bets. This calculation in practical terms: gross margin is the difference between net sales of company “A” and the cost of sales, divided by net sales, measuring the core profitability. IPOs are a great market; however it is not as easy as it may appear. Be careful in your research and seek third party advice before acting. The art to winning in the IPO market is getting in at the earliest possible stage you can and exit at the most profitable.

FIVE THINGS TO AVOID WHEN INVESTING IN IPOs

IPO investments can be staggeringly profitable; in some cases stocks can double or triple in a significantly short period of time. However, it can equally be risky, as not all IPOs are earmarked for super league stardom. IPOs do not have a trading history, unlike other listed stocks in the market, therefore leaving no time to evaluate what the market sentiment will be until the date of listing.

An IPO share price is determined by how much the market is willing to pay based on surveys the underwriting bank(s) conduct with its first round of offers with institutional investors. As you are not privy to this negotiation that takes place prior to the first day of trading to the public, it becomes apparent that you are not buying at the bottom price. Based on growth perspectives, some IPOs may appear to be relatively cheap, while others may be viewed as being expensive. Only once the IPO has been traded on one of the stocks exchanges, are you aware of which direction the share price is maneuvering.


1. Opportunity to make or loose profits

The first few days an IPO is traded can be regarded as the “unpredictable” period, so plan your selling strategy carefully. Unless you believe the IPO shares you wish to invest in are for a long-term investment cycle, expedite the sale and cash in on your gains whenever the opportunity arises. The shares can always be purchased again, once you have a feel for the share value trend.


2. Buying IPO shares on the first trading day

Even though you strongly believe in the potential of the IPO shares and want to purchase on the initial day of trading, try your best to quell your eagerness and allow the shares to settle over a few days before you decide. Most IPOs historically trade higher than their offering price on the first day of listing and eventually succumbs to profit taking on the initial day or within a few days..


3. Media hype

The underwriters number one priority is for the IPO to be successful on the first day of trading, no matter how unattractive the offer, after all it is their job to do just that. They will heavily promote through a variety of media channels with the full intention of creating hype amongst the investing public. Take into consideration that substantial shares were purchased pre-IPO by institutional investors from the underwriters and some of those investors intentions may be short term gains, which means part or all of their stocks could be offloaded on or within a few days of the company listing, with the possibility of sending prices in the opposite direction you were hoping for.


4. Brand recall investing

Brand recall is a term used by investors for a branded product company; e.g. when you buy a certain product from a company and the product is finished with, you instinctively desire to purchase from that same brand again, due to your pleasant experience, hence the term “brand recall”.

Not all branded names are great investments, even though a brand recall helps significantly when promoting the IPO. There are no guarantees that the share price will do well upon listing as every IPO has a different story to tell. Some IPOs with branded names have no solid financials to show, the company may be highly geared (in debt) and its profit margins may be marginal. Try to seek professional advice before investing as you may get a better feel for that particular IPO that has caught your attention.


5. No stop-loss plan

Try not to get emotionally involved with an IPO that you forget to mitigate your risk as risk management is a key factor when investing in stocks. Some IPOs can decline for several months after initially peaking on their initial day of listing. It is about controlling your losses, so it’s better to plan your stop-loss strategy correctly in order to protect your investment.