I have a buddy who bought shares of Facebook (Nasdaq: FB) on the day of its initial public offering (IPO).
The guy’s a boat captain. At the time, he admitted to knowing very little about the stock market, or even how Facebook would turn a profit. He just really liked Facebook — the site — and wanted to own a piece of what he thought could become an iconic company.
In the long run he was right. But it was a painful start.
Shares of Facebook debuted on May 18, 2012, for $42.05. But by early September they were trading for under $18 — down nearly 60% in less than four months!
A lot of IPOs go that way. There’s excitement ahead of the offering; people chomp at the bit to buy it as soon as they’re able. Then the stock slumps, sometimes drastically. We saw it happen with the recent Lyft (Nasdaq: LYFT) offering. Shares opened at $87.24 on March 29 — just a month ago — and they’ve already fallen under $55.
I bet a lot of folks have already bought into the Lyft IPO for the same reasons my friend bought Facebook’s on Day 1. They buy into the company’s story, as told by its founders, private equity investors, and the investment bankers bringing it to public markets. All of whom, keep in mind, have tremendous financial incentives to fetch the highest stock price possible.
My friend is also the type of guy who has to have every new thing as soon as it’s out. And I wouldn’t be surprised if a lot of IPO buyers are that same way, whether they’d admit it or can even recognize it.
The thing is, you can wait before buying an IPO…
No one says you have to buy in on Day 1.
Implementing an IPO “waiting period” can go a long way toward helping you avoid the worst of Wall Street’s IPO duds. But what does that mean?
It means resolving to not by an IPO until after a specified amount of time has passed — for instance, six months.
And then, when six months is up, you still don’t have to buy the stock right away just because you’ve held off during the waiting period. You can also resolve to not buy a recent IPO unless it has positively proven itself — which means, to trend-followers like me, you don’t buy the stock unless it’s already trending higher.
Long-time readers should know the benefits of only buying things that are already trending higher: a greater probability of success and reduced risk.
That’s true of any investment vehicle, not just IPOs. But it works uniquely well for IPOs, as any determination of trend can only be made after a minimum length of time.
Let’s say your trend rule is: I will only buy stocks if the price today is higher than the price six months ago.
It will then be impossible for you to buy the IPO stock before six months has passed, simply because, before then, it hasn’t traded long enough to as to allow a determination of its trend, according to your guidelines.
Only after six months can you answer the question: Is this stock already trending higher?
Of course, this approach could mean you miss out on some of the early gains made by IPOs that trade higher initially and never look back. But those are potential missed opportunities I think you should be willing to forgo because many IPOs — if not most of them — are debuted at untested and inflated prices.
Why do you think people say IPO stands for “it’s probably overpriced”?
A trend-following rule can absolutely help you avoid the damage done by an IPO that deflates right out of the gate, and potentially even get you into the stock at a lower price.
That was the case with my friend’s Facebook purchase. He bought on May 18, 2012, for around $42 a share and suffered through a 60% drawdown in the first several months. Had he waited for Facebook’s six-month trend to turn positive first, he could have bought in at $28 a share in December.
He wouldn’t have missed out on the social media icon’s epic success. And he could have avoided overpaying for it, along with those initial sleepless nights!
Whether you’re now eyeing Lyft’s IPO, or any other for that matter, I strongly recommend implementing a waiting period and trend rule. Let the stock prove itself capable of establishing a bullish trend before making a move.
You may not be Wall Street’s tastemaker of everything new, but you’ll increase your odds of success and reduce your risk.