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BUSINESSWEEK ONLINE: Business Week ebiz | |||||||||||||||||
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Yes, Day-Old IPOs Can Still Deliver With hot new stocks like VA Linux, it's sometimes better for small investors to make their move just after the hysteria dies down Cobalt Networks (COBT) up 482%. Foundry Networks (FDRY) up 525%. VA Linux (LNUX) up 733%. Getting in on the moon shots these stocks performed on the day they went public would be better than winning the lottery. Unfortunately, many individual investors have about as good a chance of getting IPO stocks the minute they start trading as they do of winning the lottery. Most of the beneficiaries were mutual-fund managers, trust executors, or extremely wealthy people who were owed a favor by their broker. Day traders were left to read about all that wealth creation in the press. Their only option was to buy the stock after it went public, an area of stock trading known as the IPO aftermarket. Bummer, right? Well, not exactly. In fact, a look at the data on the aftermarket shows that it isn't such a bad place to be after all. But there are do's and don'ts to trading in the IPO aftermarket, and it's important to pay close attention to those. First, though, let's examine why IPO stocks tend to rise so fast. The biggest reason is uncertainty. "No one knows exactly how much demand there will be on the first day. That's why such there's such a risk premium attached to IPOs," says David Menlow, president of IPOfinancial.com.
While individuals almost always miss out on the initial pop of an IPO, focusing on the aftermarket lets them avoid many of the risks of the IPO process. Despite all the press that the most successful IPOs get, there are plenty of others that go bust. That's when an IPO drops below its offering price. It usually happens on the first day. "There's no hard-and-fast rule about when you can call it a busted IPO, but if it's going to happen, it tends to happen on the opening day," says Menlow. By buying in the aftermarket, you can avoid busts such as Vialog (VLOG), which lost 33% on its opening day, and Digital Lava (DGV), which lost 21%. Even worse for those poor souls who did get shares in Digital Lava is the fact that busted IPOs tend to stay busted. As of Dec. 15, Digital Lava is down 66% from its offering price of $10.15 last Feb. 17. A SIMPLE CALCULATION. The flip side is that winning IPOs tend to stay winners in the aftermarket. The top 10 first-day gainers of 1999 (they averaged a 454% rise on their first days) have a cumulative price increase of 504% for the year. In other words, if you bought each of the top 10 gainers on the day after their IPO and held them until today, you would have made a greater return on your money than if you had bought the shares as they went public and sold them at the end of the first day of trading. Of course, this strategy only works if a number of underlying factors do. First, a company's fundamentals must be sound. Often with IPOs, that doesn't mean that the balance sheet and income statement need to look healthy. These days companies go public well before they are profitable. Instead, betting on an aftermarket IPO is the same as betting on the original IPO. For instance, do you like the technology on which the stock's fortunes rest? A simple calculation can help you decide whether to jump into the aftermarket. Figure the highest revenue number you can realistically imagine for the company five years from now based on the wildest expectations of its potential market. Cut that number by two-thirds. Then compare the current price of the stock to that revenue number. If the price-to-revenue ratio is above 6, which is the current price-to-revenue ratio of the Standard & Poor's 500-stock index, then the stock is probably overvalued. If it is below 6, that doesn't mean that it is undervalued. It just means that not all the expectations of future revenue have necessarily been factored into the stock price yet.
If you want to trade in the stock on the opening day, make sure to place a limit order instead. Limit orders allow buyers to name the price at which they're obliged to take the stock. A limit order keeps you from getting an unpleasant surprise when the stock rises too high for you to afford. A better idea is to wait for the second day of trading. Most IPOs that go up right out of the gate tend to lose momentum by the afternoon. By the second day, much of the initial emotion has evaporated, and the stock will start to trade in a more logical pattern. But if you do go in on the second day, you probably shouldn't place your buy order at the beginning of the day. Often, hedge funds play elaborate arbitrage games in the first minutes of the second trading day of an IPO. That's why VA Linux spiked up in the first minutes of its second day before losing nearly $50 by the end of the day. And if you're just dying to get in on the kill of the first day? Rent a tux, a limo, and a Rolex and show up at your broker's office. If no one recognizes you, maybe you'll get a few shares in the next IPO. Sam Jaffe writes about the markets for Business Week Online. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ |
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 WEB POINTERS To visit some of the sites mentioned in the story, click here: Cobalt Networks Foundry Networks VA Linux IPOfinancial.com Vialog Digital Lava | ||||||||||||
