Q: My friend who has been trading in the stock market told me to invest in an upcoming IPO that many believe is a good investment. I have always wanted to invest in the market, but I’m not sure if this is a good time to buy an IPO stock. Can you advise?—Razelle Austria by e-mail
A: Investing in IPOs can be massively profitable as a hot stock can double or triple in price in a short time. But it can also be equally risky because not all IPOs are born superstars.
Unlike other listed stocks in the market, IPOs do not have a trading history. There is no way for you to evaluate how the market will judge the stock until it is listed.
Buying a stock at an IPO price does not mean that you are buying it at the bottom. It is simply priced according to how much the market is willing to pay based on surveys done among investors by the underwriter.
Some IPOs may be perceived to be relatively cheap based on growth prospects while others may be seen as expensive. Until the IPO is finally traded on the stock exchange, you will never know where the stock is going.
How do you now manage your risks when buying IPOs? Here are the five mistakes every investor must avoid:
- Losing the opportunity to take profits
IPOs can be unpredictable in the first few days of trading. Plan your selling strategy. You can lock in your profits once you have achieved your target returns shortly after listing day.
Unless you really believe in the IPO stock for long-term investment, take the chance to cash in on your gains whenever the opportunity presents itself. You can always decide to buy it back later when you are more comfortable with the trend of the stock.
- Chasing IPO stocks on the first trading day
If you believe in the potential of the IPO and you want to buy more shares of the stock, it is best that you wait for few more days for the stock to settle down before you begin to accumulate.
IPOs historically trade higher than their offering price upon listing, but all succumb to profit-taking after a few days. Most IPOs recover after the first correction which should give you a chance to profit on a stock rally.
- Following hypes, publicity
When a company is going public, underwriters want to make sure that the IPO is going to be successful no matter how unattractive the investment offer. Expect IPOs to be heavily promoted by underwriters because it is their job to sell them to the investing public.
Avoid buying an IPO just because your broker recommended this to you or you heard from your friend that the stock is many times oversubscribed.
- Investing on brand recall
IPOs with familiar brand names are not necessarily good investments. Although a strong brand recall definitely helps in promoting the IPO, there is no guarantee that the stock will do well once it gets listed.
Every IPO has a different story to tell. There are IPOs with good brand names but no solid financials to show. For example, the company may be heavily indebted or operating margins may be below industry average.
Make sure that before you invest in IPOs, you first read the investment prospectus. Find out what the business model of the company is all about. What is the earnings track record of the company and how will earnings grow further after the IPO? How will the proceeds of IPO help the company expand and monetize its brand?
- Investing with no stop-loss plan
Every now and then, there will always be a chance that you may invest in the wrong IPO stock. When this happens, be prepared to cut your losses. Avoid getting so emotionally involved with the promise of an IPO that you forget to control your risks.
Managing your risk is more than investing in the right IPO stocks. It is also about controlling your losses. There are IPOs that steadily decline for months after peaking on listing day. Some simply trade sideways forever with fading volume turnover. It pays to plan your stop-loss strategy early on to protect your investments.