Investing in IPO's? Read this first...

Beat Ernie - Mon 17 Jul, 2006

...Not long ago, a friend, an engineer, asked me what strategies would best protect him from stock market losses. Apparently he expected a lengthy and complex stop loss strategy or guidelines for the use of technical indicators. The theoretical answer is easier than it often turns out to be in reality...

 
 
Not long ago, a friend, an engineer, asked me what strategies would best protect him from stock market losses. Apparently he expected a lengthy and complex stop loss strategy or guidelines for the use of technical indicators.

I could see his astonishment when I told him I personally had never used technical indicators to make a buy or sell decision. My protection strategy against losses has never been subject to some technical indicator line crossing another one, or going up, down or sideways.

Investing in IPO's: Why I don’t use technical indicators

Many people do use these indicators – and that’s just fine. They have their place in other peoples’ strategies – and I know some of the other members of the Profit Watch team study chart patterns a lot. But that’s not for me.

To me an investment must create "fascination" by its own story. By that, I don’t necessarily mean an emotional one! I’m talking about the fundamentals of the investment. First of all – and I believe this is the same with any successful investment – the company figures have to be satisfactory and convincing. Ideally, the macro-economic factors fit in with the company's growth potential. After all, what good can a company do if the macro-economic environment is not supporting its strategy?

The sentiment for an entire sector or type of business is another important factor. If the entire sector is going through a consolidation phase, there is more chance of owning shares in a take-over candidate and even the companies lagging the market leaders could offer good investment opportunities.

The (re-)opening of entire markets in countries such as North Korea or Cuba, where this could happen in the very long term, do attract my attention.

But let’s just get back to my friend’s initial question on how to minimize losses. The theoretical answer is easier than it often turns out to be in reality.

My "simple" recommendation is:

"Always keep a critical distance from market developments. Don’t believe everything you read or hear and be aware of how events connect. A good portion of "common sense" remains the best defence against stock price losses! Don’t put all your eggs in one basket and inform yourself thoroughly before you make an investment. If you buy a house or a car, you look for faults and repairs needed. Do this with stock market investments as well."

Investing in IPO's:...or read the IPO prospectus...

This rule applies more than ever in an upbeat market with daily IPOs and simple listings. The number of IPOs seems to be growing larger and larger by the month and the number of questionable business models are getting more common at the same time.

The critical observer may sense that many companies just try to jump as quickly as they can on the IPO bandwagon before the IPO climate turns unfavourable again, resulting in lower IPO prices.

When buying a house or a car, you make sure you get a survey done or thoroughly check it out – perhaps take the car for a test drive. You definitely get to know the estate agent and suss out the car dealer and have a first impression of that person’s credibility and whether you can trust him.

Investing in IPO's: You have to have trust

Trust is an exchange process and never one-sided. Trust calls for the respect of the other person. Trust may well be the single most important element in a business relationship for long-term success.

Is your business partner treating you with respect? Whilst this question is easily answered when it comes to buying a house or a car, the question is harder to answer when it comes to the purchase of "anonymous shares". However, there is a simple solution to this "problem", too.

Whenever you buy shares through an IPO, make sure you are aware of the goals the CEO and board members have. Are there conflicts of interest between them and the shareholders? After all, it is the CEO of the company that has the responsibility of managing the money invested by shareholders, so you can (and should) certainly demand to investigate their goals and ambitions, in order to establish a trust relationship and feel confident in your investment.

Investing in IPO's: Know your CEO

Check the previous track record of the CEO and board members in detail. Have these persons proven they can manage a business successfully? All alarm bells should ring if bankruptcies run like a red line through their CV. Why, after all, should it work out this time, with these shareholders’ money?

Just like you would not buy a house from someone where you don’t trust the survey or the estate agent relationship, you should keep your eyes peeled before investing money in a share. Don’t just buy any share based on the hype surrounding the IPO. This is the best protection against losses.

Shares are not washing tablets or stereo system with a money-back guarantee or right to exchange for a different product. You’re up against the markets after your purchase – and they can be gruesome! The invisible market shows no mercy and errors made by investors are effective immediately. Therefore, think twice before any investment!

For some reason, investors often neglect to read the IPO prospectus, but later wonder what risks led to "their" company losing money.

In an overheated IPO market these risks may appear low, but the times are changing – there is already proof that not every IPO leads to immediate share price increases, and investors are becoming more wary. Whilst banks and companies offer lower IPO share prices as incentives to attract investors anyway, the times for risk/free IPO investments in Europe seems over.

In Switzerland, where I live and work, one IPO ended up straight in the gutter just months after the first share prices were fixed. The share price of Esmertec AG (IPO in September 2005) has lost 80 percent of its all time high in January 2006.

You need to make sure you avoid similar "surprises".

If you are interested in IPOs, I strongly recommend reading the accompanying prospectus. Even though crime fiction books are a lot more entertaining to read than the detailed and highly formalized documents, the time spent on this material can be worth a lot of money. At least it may save you from unpleasant surprises and you know in time what an investment would mean for your money.

Investing in IPO's: Make sure you read before you buy

I know quite a few investors who stepped back from their initial decision to buy shares of an IPO after reading the prospectus – and they haven’t felt bad about it, quite the contrary.

Often only the detailed study of the prospectus reveals – hidden in some fine print – how risks outweigh the often colourfully expressed opportunities of the investment. Companies often employ professional speakers to highlight the good things before its IPO – but it is down to the individual investor to make a decision regarding the risks!

So please take care, when you are approached by the next round of IPO hungry companies! There’s often plenty of opportunity to buy these shares at a lower price through the stock market after the IPO. Or you could simply not buy the shares at all, which may be even better!


Until next time,

Beat Erni
for The Daily Reckoning
 

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