How to Profit from IPOs

In the stock market, few events are as exciting as initial public offerings (IPOs). That’s when privately held companies offer their shares to the public for the first time.

When a company is private, you need to buy shares through a private placement. Usually you will need to be an accredited investor, meaning you need to have a net worth of at least a million dollars (not counting the value of your primary home).

Even if you qualify, to do private placement deals you have to go through specialized brokers or directly with the company. You will also need to file paperwork through the Securities and Exchange Commission (SEC). It’s a big hassle and most people won’t even qualify.

Compared to buying private shares, buying publicly listed stocks is extremely easy and accessible. An IPO opens up previously inaccessible stocks to the world. People who have always wanted to invest in a company but could not before can do it now.

It’s like a dam opening up to release the pent-up demand. You can imagine why the trading volume on Day One tends to be so high.

Before Stock Makes It to Market

The company doesn’t actually sell directly to investors. Most commonly, it will go through an investment bank in what’s called an underwritten offering. This means that the investment bank guarantees that the company will be able to sell every share. If there isn’t enough demand for all the shares the company wants to sell at the offering price, the investment bank will buy whatever is remaining.

Prior to the actual IPO, institutional and accredited investors can subscribe to the upcoming IPO through their brokers (regular retail investors don’t have this ability). From the subscription demand, the underwriter will already know if it will be able to sell every share. If demand exceeds the supply of shares, the IPO is oversubscribed. If supply exceeds demand, then it’s undersubscribed.

Offering Price Usually Conservative

An investment bank is supposed to raise as much money for its client (the issuing company) as it can, but it also doesn’t want to get stuck with undersubscribed shares because it may lose money in that case. Since the investment bank wants to sell everything, usually it will set an offering price at which it’s confident all shares will be subscribed. In other words, it tends to err on the low side.

This is why you will often see IPO stocks open up trading at a much higher price than the offering price, indicating that market demand is much higher than the offering price.

From the company’s perspective, it’s willing to accept an offering price that might be a little low because having an undersubscribed IPO makes the company look bad. To have a stock start trading at a lower price point than the offering price is embarrassing. Moreover, an undersubscribed IPO telegraphs a negative perception to investors in regards to the company’s prospects. It could even affect the company’s ability to raise capital down the road.

Why the Delayed Trading

Ever notice that on the day the IPO occurs, the new stock actually doesn’t start trading until hours after the market open? This is because there is a price discovery process to set the opening market price.

The stock exchanges select primary market makers to help set an opening market price for the stock. Some examples on the NYSE are Citadel and GTS. These institutions, called designated market makers (DMMs), take orders from the buyers and sellers to gauge the supply and demand. Again, at this point average joes aren’t involved. It is only when an opening price has been determined and trading is opened up to everyone that retail investors can participate.

Of course, not every IPO is a good deal. There are stocks today that still trade below their original offering price. This is where distinguishing between hype and actual potential is important. But if you pick wisely, even if you don’t get first dibs, being an early investor in a successful company can be very profitable.

Which brings me to the latest investment opportunity unearthed by my colleague, Jim Pearce.

Jim Pearce is the chief investment strategist of our flagship publication, Personal Finance. Jim believes that in the coming days, the #1 technology IPO of 2021 will start minting new millionaires. That’s why he’s calling his trade the “Tech IPO Retirement Stock.”

It’s hard to imagine becoming a millionaire off one stock. But that’s exactly what happened to those who moved early enough on any one of the famous FAANG stocks. And it’s exactly what could happen to you, if you follow Jim Pearce’s IPO trade. Click here for details.