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Stocks & Bonds

How to Cash In on IPOs

Most new issues are not exploding out of the gate. That's a plus for long-term investors.

By Lawrence Carrel

When shares of Tesla Motors, a not-yet-profitable maker of electric cars, soared 41% on their first day of trading, it was a sign that the long-moribund market for initial public offerings might be reviving. But the IPO market is far from frothy, and that may be a good thing for investors who want to cash in on young, fast-growing companies before they become household names.

Experts say that now is a great time to dip your toe into IPOs. Unable to get loans from tightfisted banks, many start-ups have had to sell stock to obtain cash to finance growth. That can mean good deals for investors. To raise a certain amount of money, a company may have to sell a larger portion of itself than it would like. Or if it wants to limit the percentage of the company sold to the public, it may have to accept a lower share price than it might get in a frothier IPO market. "It's a buyer's market," says David Menlow, president of IPOfinancial.com, a Millburn, N.J., research firm.

That most IPOs are not soaring from the get-go is also a plus. On average, IPOs priced in 2010 are up 3.7% (as of September 10), according to Renaissance Capital, a research and money-management firm in Greenwich, Conn. Within a week after going public, on June 29, Tesla (symbol TSLA) was trading a dollar below its offering price.

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Other winners. Tesla is not the only company to make a big first-day splash. Among this year's successful IPOs are Green Dot (GDOT), which provides reloadable, prepaid debit cards to people without bank accounts, and Auto-Navi Holdings (AMAP), a Chinese maker of car navigation systems. Shares of MakeMyTrip (MMYT), an Indian travel site, jumped 89% on its first day, the best first-day gain in three years. And investors are eagerly waiting for Facebook to sell shares in what would almost certainly be the hottest offering since Google went public in 2004. Based on a recent venture-capital investment in the social-networking stalwart, Facebook is worth $23 billion, although the company says it's in no rush to go public.

Two kinds of investors buy IPOs: speculators, known as flippers, who sell after garnering a big first-day pop in the share price, and those who want to hold for the long term. Flippers long for the days of the technology bubble, when Internet IPOs rocketed more than 100% at their debut. Long-term investors search for the next Microsoft (MSFT). The stock, which went public in 1986, leapt 32% in its first day -- and those who held on until now have seen a return of 30,000% (even though the shares lost 15% over the past ten years).

Renaissance Capital reports that through mid September, 186 companies filed with the Securities and Exchange Commission to sell shares. Some are familiar names, such as General Motors, retailer Toys ÒRÓ Us, consulting firm Booz Allen Hamilton, and Nielsen Holdings, the television-audience rating company. Most of these are formerly public companies that were bought by private-equity firms; in the case of GM, its previous shares became essentially worthless after the U.S. government rescued the automaker.

However, the best reason to buy an IPO is to partake in the growth of a small, young company, and the coming months promise some compelling opportunities. Among them:

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Vera Bradley makes reasonably priced fabric handbags. For the year that ended last January 30, the Fort Wayne company reported that profits surged 83%, to $43.2 million, as revenues jumped 17%, to $289 million. "That's a lot of handbags," says Kathleen Smith, of Renaissance Capital. For the quarter that ended May 1, earnings more than doubled.

GameFly is the Netflix of video games. The Los Angeles-based online rental service has been profitable the past three years, although net income for the fiscal year that ended March 31 fell 88%, to $453,000, as revenues grew 22%, to $88 million. For the June quarter, profits grew 5%, to $1.6 million.

Zipcar offers a car-sharing service that allows clients to rent autos by the hour after paying an annual fee. The Cambridge, Mass., company's revenues jumped 24% in 2009, to $131.2 million, and its losses narrowed by 68%, to $4.6 million. Zipcar lost an additional $5.3 million in the first quarter of 2010. One potential shortcoming of the rental business: Barriers to entry are virtually nonexistent.

Other potential issuers include Skype, the Internet phone company, and Hulu, an online provider of television shows.

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Special risks. IPOs carry all the risks associated with stocks, plus others unique to the breed. If you invest in a young, growing company, you're typically putting your money in the hands of unproved managers. If you invest in a large, mature company, you're usually buying stock in a company whose main shareholders (typically private-equity investors) want to cash in their chips now. Large IPOs often hit the market bogged down with debt. And, of course, if you can't buy shares at the offering price -- the price at which insiders sell to the market -- you often end up being the dupe who buys from the flippers at the top of the pop.

Individuals will find it difficult to get in on a hot IPO. Typically, underwriters sell to institutional investors. Retail investors sometimes get shares, but it all depends on your relationship with the broker. Brokers are guarded in discussing how they determine whether a client gets in. A spokesman for Morgan Stanley Smith Barney, for example, says the brokerage's customers must be "qualified," which typically means a client must have at least $1 million with the firm and have a high tolerance for risk, "because IPOs are riskier than other investments."

Retail investors should look to discount brokers. Fidelity has an arrangement to get shares in deals led by private-equity firm Kohlberg Kravis Roberts & Co. Qualified Fidelity clients need a minimum of $100,000 in certain assets or must make at least 36 trades a year.

Groucho syndrome. Then again, if you are able to get in on an IPO, it may be a club you don't want to belong to. "If you can get in at the offering, it's probably a bad idea," says Tom Taulli, coauthor of the book Investing in IPOs. "If it's a hot idea, brokers will give it to clients who make them the most money. If you get in, you can assume it's not so hot."

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Some experts recommend waiting until the company issues its first earnings report as a public company. During that time, you can see how the stock trades. Then, after a 40-day quiet period, underwriters may issue analyst reports on the stock. The first quarterly results will show whether management can deliver on earnings forecasts, manage expectations, and deal coherently on conference calls with analysts and money managers. Another reason to wait is to see what happens when the lock-up period ends. The lock-up prevents insiders from selling shares anywhere from three to 24 months after the IPO date. If everyone bails when the lock-up expires, it means they don't have much faith in the business.

Should you be lucky enough to get the offering price, you still need to do some fundamental research. After the SEC approves the offering, underwriters put together a prospectus, known as a red herring. This dense document contains high-level disclosures of the private company's financials, both past and present. Check out the prospectus summary, which lists what the company does as well as its competitive advantages, risks and potential for making money. Prospectuses can be found at www.sec.gov.

In general, you want profitable companies with unique products or services that have high barriers to entry. "Companies that generate good fundamentals in a recession are definitely worth a look," says Francis Gaskins, president of IPO Desktop, a financial-analysis Web site. Both IPO Desktop and Renaissance Capital offer IPO calendars and analysis of new issues.