For starters, an initial public offering is by definition a type of stock offering in which shares of a company usually are sold to institutional investors that in turn, sell to the general public, on a securities exchange, for the first time. Through this process, a privately held company transforms into a public company. Initial public offerings are mostly used by companies to raise capital for expansion of the firm.
Why should you care? Because it is a widely held misconception that IPO’s can earn the investor a sizable return almost instantly. While there is some truth to this, it mostly applies to the extremely high net worth or institutional investor. This is because when the privately held company goes public the investment banking firm more commonly known as an underwriter will handle the details of the offering such as the initial offering price and compiling and issuing the prospectus. The prospectus is a lengthy legal document that must accompany all new issues of equity securities such as stocks and mutual funds. High net worth investors usually can get in on what is known as the pre-offering price per share.
Here is where it gets tricky. Word usually leaks out to the public that a company will soon start selling shares of stock and the offering price will be say $10.00 per share for example. While this is all perfectly legal it is possible to make MAJOR mistakes when interpreting this information. The investor mistakenly assumes that they can get shares of a hot stock when it begins trading on the open market at the previously mentioned $10.00 per share. So what do they do? They will put in a market order to their brokerage house for 1000 shares, thinking that they will only be spending $10,000 for the trade. What they don’t know is that most of the time there are hundreds if not thousands of other investors who placed orders ahead of them. Remember that the stock market operates a lot like the checkout line at the grocery store. There are almost always shoppers ahead of you but the price for your groceries changes as you move through the line to the cashier. This is the case with stocks.
Getting back to our investor. They anxiously await the day the stock will start trading on the exchange. That day comes, the stock starts trading, their order gets executed and the get their 1000 shares of stock. Hooray!! But when it comes time to pay for the trade they get a bill for $30,000. They look at the trade confirmation and it shows they paid $30.00 per share for the stock instead of $10.00 which is what was published. What happened? They now owe three times what they planned to pay and by regulation, they have two days to pay up.
Remember what I said about being in line at the grocery store with the price for your groceries changing as you move through the line? It is all about supply and demand. If there is a fixed supply and heavy demand prices go up. And if you place a market order for one of these stocks, you are telling your broker you will take any price as long as you get the stock. Remember, all of this is perfectly legal. Yet many investors have made this mistake and cried foul when they got the bill. To compound the problem, the investor sometimes immediately sells the stock because they don’t have the money to pay for it. This is a trading violation more commonly known as freeriding- buying a stock without the ability to pay for it.
My only advice to those who insist on taking a chance with IPO’s is to place what is known as a limit order instead of a market order. A limit order is where you tell the exchange the maximum amount you will pay for the stock and if it opens or moves quickly past that price the order does not execute. If it is lower than your limit price and the shares are available, you get your stock for cheaper than you planned.
I’ll close today with a real life example of an IPO that burned virtually all of my clients who thought it was a sure thing and went for it. The year was 2014 and the stock was Alibaba. The word was that the IPO price was going to be $10.00 per share. I begged my clients NOT to buy it. I told them the $10.00 share price was not realistic at all. I was convinced that the price would sky rocket on speculation and that being a foreign stock from a communist country, (China), it was highly risky. I used all of my powers of persuasion with every single client and could not convince a single one not to do it. Worse yet, none of these clients used limit orders. All of them used market orders. When the stock started trading it opened at $90.00 per share! As I said every one of my clients who purchased shares paid at least a 900% markup. Many were wiped out financially and the rest is history.
So the moral to my story is that if you are convinced IPO’s are for you, be VERY careful.
If you have any questions regarding this article or any other investment matter, feel free to call me at 480-296-9556.
Rudy Eidenbock, Financial Advisor, RJFS
Office: 480-307-9909/Cell:480-295-9556/Fax:480-907-1413, 4111 E. Valley Auto Dr. #104, Mesa, Arizona 85206
Purity Wealth Advisors is an independent firm. Securities offered through Raymond James Financial Services Inc. Member FINRA/SIPC
Purity Wealth Advisors is not a broker/dealer and is independent of Raymond James Financial Services Inc., Member FINRA/SIPC. Securities offered through Raymond James Financial Services Inc. Investment advisory services offered through Raymond James Financial Services Advisors, Inc.
All investing involves risk and you may incur a profit or a loss. There is no assurance that any investment strategy will be successful.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Rudy Eidenbock and not necessarily those of Raymond James.