Investing in companies going public on the stock exchange can be very alluring.
Many private investors dream about hitting the next jackpot, like Amazon, Microsoft, or Google.
Did you know that if you had invested 18 USD in Amazon’s initial public offering (IPO) in 1997, you would have more than 12 million by 2020?
The truth is that for every Amazon and Google, there are thousands of stocks that completely flop on the stock exchange.
Many IPOs fall flat within a year of going public.
In fact, studies have shown that you would be better off investing in an index than investing in IPOs.
Why is that? What are the shortcomings of IPOs?
- The companies are expensive
Companies only go public when the market is at a high level. The people selling the company want to get a good price for what they are selling. Many IPOs take place at the end of a long bull run. You simply cannot find an IPO that is cheap.
- IPOs come with professional salesmanship that’s hard to resist
It’s expensive to take a company public. The company has to make a prospectus and get help from an investment bank. There’s a lot at stake and highly professional marketing behind this whole process. It’s hard to resist IPO salesmen.
- Private investors’ own dreams of hitting a jackpot pump the price up
There’s so much excitement about an IPO, and it’s hard not to get carried away. You sometimes see that the stock trades at a high price just after going public, only to crash a few weeks or months later. Why is that? Investors hope that the IPO is the next big kill, and they’re afraid of missing out from the get-go.
Still interested in IPOs? Well, you can still invest in them, but you have to be careful.
What are some rules you should set up for yourself when investing in IPOs?
Here are a few:
1. Check the Prospectus
So many private investors don’t even look at the prospectus before buying those hot IPOs. That’s the biggest no-no of them all.
You have to open the books and look at the numbers.
At first, you just glance through them to try to figure out if you should proceed and research some more.
Does the company even make money? Many companies going public are actually not profitable.
Don’t presume that the company you’re interested in is profitable just because the management talks of a glorious future and some analysts predict they’ll become the next big thing.
That’s just hot air from crafty salesmen. You want proof.
2. Follow a Checklist
In theory, you should do exactly as you do when investing in any other public companies. You should follow a checklist to make sure that:
- The company is growing and profitable
- They have competitive advantage
- You like the management
- They haven’t run up too much debt
That’s just the beginning. You can download my checklist right here.
The goal of the check list is to ensure that you invest in a company that will be bigger in ten years. Keep that in mind.
3. Calculate What It’s Worth
Even the best company can be a lousy investment if you buy it too expensive.
Many IPOs get hyped and sell at a very expensive level.
You can learn how to calculate what a company is worth in my e-book right here.
4. Limit Your Exposure
Don’t invest more than you can handle losing.
IPOs fall in the category of risky investments, and you shouldn’t place more than 10 percent of your investable capital in risky investments.
It’ll be volatile and unpredictable. Placing a significant amount of your wealth in an IPO is like eating lollipops for breakfast – it will make your blood sugar unstable and make you irritable all day. You might even have trouble falling asleep at night because your heart is racing.
Having a huge share of your portfolio in an IPO will make it all very unstable, and you run the risk of losing your cool.
Consider the money you place in an IPO money lost. It’s almost as risky as betting in a casino.
Other Jackpot Investments
Studies have shown that investing in a fund that matches a stock index is, generally speaking, a better investment than IPOs.
In other words, you are more likely to hit the jackpot by betting on a decent ETF than betting on IPOs.
Also, remember you might get a much better shot at the IPO later on when the company has matured and proven itself as a business.
Many IPOs’ stock prices plummet later on. The company might become cheap when going through some kind of event or going through a general market crash.
After the dotcom bubble, Amazon fell from 110 USD per share to 6 USD per share. It was a much better and more secure investment in 2001 than in 1997 (the internet was still a bit exotic in 1997, but by 2001 everyone knew who Amazon was).
Finally, don’t forget that there are many other companies out there that can become very lucrative investments.
Did you know that if you invested with Warren Buffett’s Berkshire Hathaway from 1964 until 2020, you could have turned 10,000 into more than 200 million?
Berkshire Hathaway never had an IPO and never invested in IPOs.
Buffett bought up all the shares of an old textile company and turned the shell into an investment company. He avoided all the pomp and glory of an IPO and tiptoed through the back door.
You can learn to invest like Warren Buffett by downloading my e-book Free Yourself. You can get it for free here.