IPOs: How to Kick the Tires

Not all initial public offerings are created equal. Here's what investors should look for when buying newly issued shares

by David Bogoslaw

It's been less than a week since the Blackstone Group's (BX) much-vaunted initial public offering, and other private equity firms are eyeing a foray into the public market, starting with the Carlyle Group. Should investors respond to this trend with eagerness or wariness?

While an IPO allows investors to participate in what's usually a hot sector, a healthy dose of skepticism is always advisable when considering buying a newly issued stock. First of all, there's nothing accidental about the timing of an IPO. As investment guru Burton Malkiel says in A Random Walk Down Wall Street, an IPO is usually scheduled by a company's managers to coincide with a prosperity peak for the company, or with the height of investor enthusiasm for a current fad.

Healthy skepticism

Some experts recommend that you wait until after the so-called lockup period, or the first six months of trading, has passed. This allows you to see how well the stock holds up to additional selling pressure, or to take advantage of a price decline.

The Blackstone IPO, which was valued at $33.6 billion, was touted as the biggest IPO of the past five years. Ten times oversubscribed, the shares opened at $31 last Friday and had risen 13% by the market close that day. By Tuesday, however, the price was down to $30.75.

It isn't hard to see why private equity firms have become the talk of the market when you consider the rise in demand for financial services and the economic strength that industry has demonstrated in recent years. Private equity accounted for 48% of merger-and-acquisition value and 20% of volume during the first five months of 2007, vs. 32% and 17%, respectively, for all of 2006, according to Thomson Financial. But not everyone is buying the hype, with skeptics citing inflated prices and the absence of a track record of trading publicly.

Variable Quality

If IPOs are pricing fairly strongly lately, it's because the IPO market takes its cue from the broader market, where valuations have increased over the past year. Given the greater cyclicality of the IPO market vs. the broader market, it's likely that if there's a slowdown in the broader market, we'll see a more dramatic drop in IPO issuance, says Michael Hoder, a stock analyst at Morningstar Funds (MORN).

And investors would be missing some good opportunities if they think it's wiser to stay away from IPOs in a weak market cycle, according to Paul Bard, vice-president of research at Renaissance Capital in Greenwich, Conn. When the overall market is weak, only companies that have strong fundamentals get pushed through, often at very attractive prices.

Conversely, when the IPO market gets hectic, deal quality tends to diminish, as at the height of the tech bubble in 1999. Seeing the market's willingness to absorb IPOs, banks are happy to oblige by pushing even lower-quality stocks into the public sphere, says Bard.

In any market, investors looking to buy shares of newly public companies should do their homework. This week, Five for the Money takes a look at five things investors should look for when considering an IPO.

1. Company Fundamentals

Don't let the lack of transparency and hype around hot sectors cloud your vision. As with any company, its financial track record, competitive position in its industry, business model, and earnings power will tell you most of what is worth knowing.

After the quality of a company's management team, its market opportunity and products are the key factors to look at, according to Bob Davis, managing general partner at Highland Capital Partners, a venture capital firm.

"We like to see a market we believe is expanding and a market we believe is huge with a capital H," Davis says. He'd rather pick a company with a small share of a $5 billion market than one that has the dominant position in a $50 million market.

For Bard at Renaissance, it's not only how ample the market opportunity is but whether a company is able to grow faster than the market.