With the initial public offering (IPO) market the strongest it's been since 2007, according to data provided by Thomson Reuters, and e-commerce giant Alibaba's record-setting IPO still attracting attention, many average investors are picking up on these new-to-market, buzzworthy securities and wondering if they can (and should) get into the action.
The IPO frenzy is expected to continue, with German internet provider Rocket Internet and French online retailer Cnova garnering headlines. But before jumping on the bandwagon, here are some key considerations to help retail investors determine if these investments are the right fit for their portfolios.
Although IPOs and new-to-market securities have the potential to deliver returns, they also carry serious risks for even for the savviest of investors. Here are some things to consider when you are thinking about investing in a new public company.
How do I access an IPO? It can be difficult for individual investors to "get in" on an IPO because initial shares are allocated to mutual funds, hedge funds, pension funds, insurance companies and high-net-worth individuals. By the time everyday investors have a chance to purchase shares, they're typically found on the secondary market, and they have already traded. This means the price may have significantly fluctuated, the Securities and Exchange Commission warns. Depending on when you decide to make your investment, the share price could be higher or lower than the initial offering price. When we discuss retail investors taking part in an IPO, we're referring to buying stock once the IPO shares have begun trading.
Do your homework. Investors have a lot to consider before deciding to invest in a newly public company. Start by researching the company to develop an understanding of its business model, fundamentals and management team. Read the prospectus, check out the growth and earnings potential of the company, and develop a case as to why it might succeed over the competition.
Does the company have strong earnings potential, or are they struggling to turn a quarterly profit? Could buying these shares increase your risk profile? What are the implications of a market downturn on the value of these stock holdings?
Prior to buying shares, you should be able to confidently address:
-- how this investment could help you meet your investment objective and how it fits into your overall strategy
-- how the company makes money
-- what are its key products or services
-- potential risks and rewards associated with investing in the company
Understand the risks. Once you complete your research, you may feel comfortable with your understanding of the company's fundamentals, but it's important to remember that investing in these securities can be risky for even the most well-informed investor.
Investing in new-to-market securities is like investing in any security -- there are no guarantees. And there are several reasons why they may underperform, leaving an investor holding shares that trade below the initial share price.
Media hype doesn't always help. Internet discount coupon provider Groupon was a highly anticipated public offering in 2011 but after pricing shares at $20, it rarely moved above that price. Its shares have been trading under $10 a share for most of 2014.
Groupon is a perfect example of how an IPO can get overvalued because of media hype or a market boom. When there are so many investors trying to get a piece of a popular IPO, underwriters can price IPO shares above what the company's price-to-earnings ratio would typically justify. That means those share prices may not be maintained once on the secondary market.
As is the case with all stocks, during a market correction the company's shares may fall back to reflect its "normal" valuation. If an investor buys into an IPO during a market boom, they risk holding shares that could be hard to sell during a market downturn.
There is a lack of history or information. New-to-market securities don't have the historical performance or data or other important details publicly traded securities are required to offer. After all, one benefit of being a privately held company is that you don't have to disclose as much information about earnings, assets and future projections. Even if a private company discloses a fair amount of information, it's still more difficult for an investor to predict how the company will perform post-IPO, as that's often a game-changing moment for a company's strategy.
There are also plenty of potential benefits. Why consider buying into a newly public company? For one thing, it's a way to get in on the "ground floor" of a company if the investor believes it has long-term potential. If you think the company is going to perform well over the long-term, it may be cheaper to buy shares early on.
Some of today's most valuable companies have seen their stock value increase tenfold or more since going public, the Associated Press has reported. For instance, since Mexican restaurant chain Chipotle went public in January 2006, its stock has risen well over 1,000 percent. Had an investor bought shares in the IPO, Chipotle may have been among their portfolio's all-star performers.
And there's the opportunity for savvy investors to see rapid short-term gains. The camera maker GoPro Inc.has been 2014's best-performing U.S. IPO as of the end of September, with its shares often trading at triple above its $24 IPO price.
Make the decision. If you're ready to learn more about IPOs and begin researching new-to-market companies, you can look for tools and resources to help you learn about upcoming public offerings and performance of newer securities. ShareBuilder's IPO Center offers educational content to help investors make decisions about which companies to invest in, and lets you track upcoming IPOs to determine which of these securities may be the right fit for your portfolio.
Make sure you reach your own conclusions when it comes to buying or selling new-to-market securities. Keep in mind the companies mentioned here are only examples -- they aren't intended to be used as a basis for any investment decision.
Ultimately, it's fun to get excited about upcoming IPOs and the potentially lucrative returns they may offer. Just make sure you seriously consider all of the pros and cons before you get in line for the latest record-breaking deal, and as always, do your homework on the company you're investing in.
Investments are subject to market risk, including possible loss of the principal amount invested.
Initial Public Offering (IPO): IPO shares have no trading history, are speculative and are not suitable for all investors. Only you can determine if investing in an IPO is within your tolerance for risk and appropriate for your investment goals. Before investing in an IPO, you should read the prospectus carefully.
Securities products are offered by Capital One ShareBuilder, Inc., a registered broker-dealer and Member FINRA/SIPC. Capital One ShareBuilder, Inc. is a subsidiary of Capital One Financial Corporation.
Dan Greenshields is president of Capital One ShareBuilder. In his 12 years with the company, Dan has served as CFO, an executive officer and also as a member of the board of directors prior to joining full time as an employee. Dan is a Chartered Financial Analyst and a member of the Seattle Society of Financial Analysts.