Friday, November 10, 2006

Buying an IPO: Free Money

I had previously mentioned the Bare Escentuals IPO (Nasdaq: BARE) that I received from my stock broker, Waterhouse. Since most people are probably not familiar with the process of getting Initial Public Offering (IPO) shares, I thought that I would write an overview of the process. My caution here is that I am not an expert. IPOs represent an added layer of risk that many investors are not willing to take. Nevertheless, if one is willing to "invest" the time to understand the IPO process, and more importantly the companies in which you are investing, buying IPOs can be a relatively low-risk venture that is like getting free money.

First of all, there are two online brokers that I use which offer IPO shares. These are Waterhouse, and E*TRADE. Of course, there are other brokers that offer IPOs, but I'm not yet involved with them. I recently found that Fidelity offers IPOs. However, their minimum requirement of $500,000 in a Fidelity account makes that venture prohibitive for most people.

The first step in getting an IPO is passing an eligibility questionnaire. You will be asked questions about your income, your liquid net worth (excluding the value of your primary residence), your investment experience, and your investment objective. My only advice here is to be honest when answering the questions.

Once you pass the IPO eligibility questionnaire, the next stage is to wait until the broker announces that they are taking conditional offers on a new IPO. At that time, you should go to the broker website, read (or at least skim) through the prospectus, and place a conditional offer. In general, a conditional offer is placed in multiples of 100 shares, and you will indicate the maximum number of shares you are willing to buy at the offer price. Up to this point, you are not under any obligation to buy the IPO shares, and may cancel your offer up until the allocation phase. However, it is your responsibility to read and understand the "risk factors" that are listed in the prospectus.

Next comes the pricing (if the IPO is not withdrawn). Note that pricing occurs after hours on the day before the IPO begins trading. You will be asked to confirm your conditional offer (usually by midnight of the same day). This step is very important! You have to make the decision at this point if the IPO is one that you really want to participate in. If you decide that you don't want the IPO, you can still cancel at this time. Warning: not all IPOs go up, so choose carefully! I cannot overemphasize this point: buying an IPO can involve significant risk.

The last stage is the allocation phase, which occurs in the early morning hours on the day that the IPO begins trading. Here you will be randomly allocated shares based on the level of interest in the IPO. However, I estimate that 80-90% of the time, I was not allocated any shares after completing this whole procedure. In practice, I have usually placed conditional orders for 200-300 shares of a new IPO, and have been allocated either 100 shares or nothing.

In the case of Bare Escentuals, the IPO priced on Thursday, September 28 at $22 per share. I placed an order for 300 shares, and was allocated 100 shares. It began trading on Friday, September 29 when it closed at 27.15. I later sold the stock at $30, and made a profit of $800.

As with any investment, I advise you to do some outside research of the companies that you are potentially investing it. Two resources I use to gather information about new IPOs are IPOhome and MarketWatch. Please use these resources before you invest. One last note, sometimes you will see what is called a secondary offering for stocks that are already being traded on a stock exchange. I generally avoid these because the potential for quick gains is not as good.

In summary, buying an IPO can be a big hassle, and you most likely won't even get any IPO shares in the end. But if you play the IPO game right (and avoid poor quality IPOs), you can end up with an almost certain profit. It is like getting free money.



Smarty said...

The maximum shares you can put in for TD Ameritrade is 1000. I put the max for IPO SPR but only 100 got filled. I was disappointed. What IPOs are on your watch list?


pfstock said...

I am never allocated more than 100 shares in any IPO worth buying. Spirit AeroSystems (NYSE: SPR) priced slightly above its $23-25 range at $26 in November, and is now trading around $30. I didn't participate in this offering, but I'm glad you made a profit.

In another comment, you brought up a good point that I didn't mention here. For Fidelity, you can also qualify for IPOs by making at least 36 trades per year, so you don't need to meet the prohibitively high asset requirement.

Currently on the IPO horizon is AeroVironment (Nasdaq: AVAV) which is expected to price on Monday, January 22. The company was recently mentioned by Jim Cramer (Mad Money, Booyah!), and he will help to drive the buzz and hype behind the stock.