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Buying IPOs: It's all about knowing the sweet spot of the cycle

STEVE COLE - christie & cole stu/©2009 STEVE COLE - ALL RIGHTS RESERVED - christie & cole studio inc. - WWW.STEVECOLE.COM

Retail investors are generally better off avoiding initial public offerings (IPOs). About the only time they are worth buying is when stock markets are in a funk. That window of opportunity was opened by the recent bear market but may now be just about closed.

True, IPO prices tend to spike upward on the first day of trading. But those gains mainly accrue to the brokerage's best customers. They are favoured with allotments before the spike occurs, while ordinary retail investors usually don't get a chance to buy until the first day of trading, after the stock has bounced.

IPOs are sometimes hard for retail investors to resist. Brokerages want the new issues to do well, so they tend to engage in heavy promotion. The spotlight is shone on the positive aspects and the negative ones are left to the prospectus.

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An expert on IPOs, University of Florida Professor Jay Ritter, found that stocks newly listed on U.S. exchanges from 1970 to 2008 trailed stocks of similar market capitalization by an average 4.7 per cent one year after launch, and by 4.0 per cent after three years. But IPOs floated in bearish environments, he noted, outperformed the market.

What the experts say

Most serious books on investing advise against buying IPOs in bullish times.

•In A Random Walk Down Wall Street, Burton Malkiel notes that: "Investors should be very wary of purchasing today's hot issue. Most initial public offerings underperform the stock market as a whole …. The managers of the companies themselves … try to time their sales to coincide with a peak in the prosperity of their companies…"

•In The Intelligent Investor, Benjamin Graham states: "An elementary requirement for the intelligent investor is an ability to resist the blandishments of salesmen offering new common stock issues during bull markets. ... Some of these issues may prove excellent buys - a few years later when nobody wants them."

•In The Investment Zoo, Stephan Jarislowsky writes: "New issues are typically well promoted …. My experience is that you can buy nine out of 10 new issues at a lower price a year or two later. … I generally avoid new issues…"

•In The Future for Investors, Jeremy Siegel argues: "Investing in IPOs is much akin to playing the lottery. There will be a few huge winners, such as Microsoft and Intel, but those who regularly invest in all IPOs will fall significantly behind those who invest in stocks already trading in the public markets."

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•Wall Street Journal personal finance columnist, Jason Zweig, declares: "history shows that IPOs can more accurately be said to stand for "It's Probably Overpriced," or "Imaginary Profits Only," or "Idiotic, Preposterous, and Outrageous."

As noted, it appears the best time for retail investors to buy IPOs is during, or just following, a severe market downturn. The number of new issues dwindles and the ones that come out tend to be from the strongest of companies. Then, as markets recover, the number of IPOs ratchets up while the quality drops and valuations rise.

Is it too late?

So, are we still in the sweet spot of the IPO cycle?

We could pretty well be at the end of it. There was a tremendous rally in 2009. And 2010 is proving to be a strong year as well, as highlighted by the banner month in September and ongoing momentum in October.

The second half of 2008 and early 2009 was likely the best time to have bought IPOs. The market correction in the middle of 2010 might have been another. The ducks were definitely not quacking and plenty of IPOs were cancelled or rolled back.

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Still, underwriters were struggling with IPOs as recently as August. And according to Bespoke Investment Group, IPO activity in the U.S. has averaged about 14 per month in 2010, far below the average of 25 per month from 2004 to 2007.

Thus, the door could yet be open a crack for those willing to take the chance. At least buying at this time would be better than a year or two from now if the recovery continues to gather steam.

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