Play the game

This fact should come as no surprise considering that new issues are high-risk, high-reward investments. Pick the right stock and you could score big, but the more likely scenario is that your hot IPO will be languishing below its offering price in a few years.

This series of IPO Basics includes a definitions of terms found on financial statements, covers the basic definitions needed to understand the IPO process, and looks at the prospectus. In this final report, we discuss investment strategy.

The ground floor
Obviously, one of the best ways to invest in an IPO is to buy shares at the offering price from one of the banks managing the deal, before the stock starts trading. New issues are usually reasonably priced by the lead underwriter, which typically hopes for a 15% premium above the offering price when the stock starts trading.

For your average retail investor, however, buying shares at the offering price before the stock starts trading is a difficult task. But it's a bit easier now that banks have made an effort to reach out to the retail investor community through alliances and mergers.

To buy an IPO at the offering price, you'll need to have an account with a broker that has access to that deal, meaning one of the banks that is part of the selling syndicate. These will be brokers that also have corporate finance divisions, such as Merrill Lynch, Wit Capital, or Salomon Smith Barney, or discount brokers that have signed a distribution alliance with a traditional investment bank, such as E-Trade or Schwab or DLJDirect. The names of the banks on the syndicate for any given deal can be found by looking at the "Underwriting" section in a company's SEC registration.

Tell your broker
Then, it's just a matter of letting your broker know how much you would like to invest in the IPO. Whether you're successful depends on many factors: how many shares are being offered in the deal (the more, the merrier), how large an allocation your broker's bank is getting (the lead underwriter will have the largest allotment), how large your account is, how much trading you do, how close your relationship is with your broker, how well your broker knows the business, how successful your broker is, etc.

Many brokers, especially the greener ones, don't even realize they could get IPO allocations for clients. Brokers get fat commissions for selling shares in new issues, so they're usually reserved for the best, most industrious salespeople.

If you want to invest in an IPO but don't have a relationship with one of the managing banks, you can also try to start an account, making it a condition that you receive some shares in the new issue you're interested in, but you may not have much luck with this tactic. IPO shares are saved to reward a firm's biggest, most active, and longest-standing customers.

With an electronic brokerage that's participating in an IPO, the allocation process is more objective, although no less difficult. Some firms, such as DLJDirect, only give shares to customers with a certain account size; others allocate shares based on statistics such as trading frequency to reward their best and most profitable customers.

Wit Capital uses a quasi first-come, first-served system, allocating shares via a random lottery to all investors who respond to their solicitation e-mails within a certain time frame.

Of course, even investors able to get shares in an IPO willnot be able to sell those shares right after the stock starts trading, a process called flipping that is often employed by institutional investors to boost returns. Try to flip, and you'll probably never get an allocation in an IPO again, at least not from the same broker.

Electronic brokers are particularly harsh against quick sellers. Wit Capital, for instance, says it puts those who sell their IPO shares in the first 60 days at the bottom of the priority list in upcoming deals, while E-Trade also punishes flippers by restricting allocations in the future.

Patience is a virtue
If you can't get in on an IPO at the offering price, what's the next best time to invest? Analysts have differing opinions on this, but most agree on one point: You must be patient.

It may be incredibly exciting to watch a stock like Netscape or theglobe.com soar on the first day of trading, but it's a potentially dangerous way to invest, especially if you're planning to be in for the long term.

When a stock first starts trading, its price will nearly always rise to an artificially high level. First of all, investor demand is often unusually heavy because of the hype surrounding an IPO and the strong selling effort employed by the syndicate

In addition, the lead underwriter is legally allowed to support the stock price of a newly public company, either by buying shares in the open market or by imposing harsh penalty bids on brokers who return shares in a new issue.

While this early momentum can last for several days or longer, it ALWAYS ends, at least temporarily. "Within three months or four months the stock price (of an IPO) will usually sag," said Kathy Smith, an analyst at the Greenwich, Connecticut-based Renaissance Capital, an IPO research firm that manages the IPO Fund. "A wait-and-see approach can really pay off."

For example, Amazon.com's stock gained a bunch on its first day of trading but it was actually trading at less than its offering price a week later. Amazon's a bit of an unusual case, but most new issues will show some significant price weakness within the first six months of trading.

The research report
Another benefit of waiting a bit before investing in a new issue is the analyst research report, which comes out about 25 days after a stock starts trading. Because the analysts who first start covering a new issue work at the banks that helped bring the company public, these "rah-rah" reports nearly always include a "buy" or "strong buy" rating and rarely make much of an impact on a stock price. However, they do provide some food for thought as well as revenue and earnings estimates which can help an investor decide on an appropriate valuation.

If you're determined to get in on an offering on the first day, always use limit orders, which allow you to set the maximum amount you're willing to spend. Limit orders may not always get filled, but you may get saddled with a wildly overvalued stock if you use a regular market order.

Struggling IPO market
Just like all markets, the world of IPOs goes through cycles. When it's in a downturn, as it was in the spring of 1996, deals that are lucky enough to get out are often priced at bargain-basement prices. That's when the smart investor is looking hardest to jump in.

Take, for instance, the March 1996 debut of Internet auctioneer Onsale, which could barely find any bidders at a lower-than-expected $6 offering price; the stock was below $5 within weeks. Later in the year, when the market turned around for Internet stocks, Onsale's price surged more than 500%.

A first-class jockey
Another strategy analysts recommend is buying on the strength of the underwriter. Year in and year out, deals from Goldman Sachs, Merrill Lynch, and Morgan Stanley Dean Witter perform near the top of the list.

Along the same lines, say analysts, stay away from the small underwriters or the tiny deals. Renaissance Capital's Smith defines a small underwriter as a bank that does not do its own research and only sells to individual investors. "Institutions may be deal hogs, but they demand research and provide credibility," she says.

A small deal is an IPO which places a company's market value (shares outstanding times offering price) at less than $50 million, Smith adds.

Funds and (gasp!) shorting
If you don't have the time to do adequate research for your own stock picking, you may want to consider putting money in a growth-oriented mutual fund that invests heavily in new issues. Renaissance Capital has started such a fund, and you can contact Morningstar for others out there that fit the bill.

Finally, an investor may want to consider shorting a new issue, which is when an investor sells borrowed stock in hopes of buying it back at a lower price and pocketing the difference.

Shorting a hot IPO is a dangerous strategy that Smith says requires a "stomach of steel," but if timed right (wait until all the initial momentum has faded), the opportunities are large. In order to short a stock, you'll have to find shares to borrow, which isn't easy in a new issue, and you'll need a margin account with your broker.

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