Three Reasons You Can't Buy IPO Shares

If the goal of investing is to buy low and sell high, then getting in on an initial public offering -- more commonly called an IPO -- must be the ticket to riches. Buy a hot new stock at a discount and then sell it for a huge profit just hours or days later, right? Seems like a sure thing.

But for most individual investors, that dream of getting in on the IPO action will never be realized. And that's not necessarily a bad thing.

For every fairy-tale stock that takes off like a skyrocket following an IPO, there are cautionary tales of many more IPOs that post lackluster results. Some even crash and burn.

3 Reasons You Can't Join the IPO Club

First, understand the process: When a company goes public and issues stock, it wants to raise capital and make shares available to the public. The IPO is underwritten by an investment bank, broker dealer or a group of broker-dealers. They buy the shares from the company and then distribute the shares to investors.

"The brokers find a home for the largest pieces. If there is a lot of interest, the shares go very easily into the hands of institutional investors," says Rob Lutts, president and CIO of Cabot Money Management in Salem, Mass.

Reason No. 1: Big buyers easier to find. Selling a million shares to an institutional investor is much more efficient than finding 1,000 individuals to purchase shares.

But even big institutions often don't get as much of the action as they would like because the initial public offering may be quite limited.

"Especially with a smaller IPO, nobody really gets 100% of their fill. In fact, no one gets more than 10% of their interest in the allocation," says Kathleen Shelton Smith, principal at Renaissance Capital, a global IPO investment adviser, research and management company.

Reason No. 2: One hand washes the other. Institutions that get to participate in the initial public offering often do a lot of business with the brokers underwriting the deal.

"It's stacked in favor of large asset managers, but it is a money game and everyone is in it to make a buck and that is where it goes -- it goes to the best customers of those brokers," Lutts says.

Reason No. 3: Your broker perceives you as poor. Management, employees, friends and families of the company going public may be offered the chance to buy shares at the IPO price in addition to investment banks, hedge funds and institutions. High net worth clients may be rewarded with IPO shares from time to time as well.

If you have an account with the broker bringing the company public and happen to keep most of your vast fortune with that broker, you may be able to beg your way into a hot IPO.

"That still doesn't mean you're going to get in. For LinkedIn's (IPO), for instance, unless you were friends or family, you were probably out of luck," says Jeremy Carpenter, portfolio analyst with Investor Solutions in Miami.

Lutts agrees. "I manage $500 million and I can't get the really hot ones."

Lucky to Lose Out

Once the stock is trading on the exchange, small-fry investors and big-time professionals have plenty of opportunity to buy shares. In fact, waiting for this opportunity can be a smaller investor's best strategy when it comes to new public companies.

"So far this year, over 40% of the IPOs are trading below their IPO price. It may be smart for the individual investors to look at IPOs, but maybe they shouldn't feel that they're missing a whole lot," says Shelton Smith.

In fact, investors may be lucky to lose out. Case in point: In 2005, Refco, a global clearinghouse for derivatives that served more than 200,000 customers, went public. Within months, it fell into bankruptcy.

"It was a financial company that did futures, and everyone thought that they were the greatest company ever and there was a big hoopla when they decided to go public," says Carpenter. "Three months later they have accounting fraud and their CEO is hiding money and debt. You just never know who is going to make it or who isn't," he says.

Also, the discount offered at the initial public offering generally is not that great. According to Shelton Smith, the IPO price should be, on average, a 13% to 15% discount from what might be the regular trading price.

How to Buy New Stocks

New IPOs often have limited histories and their valuation can be somewhat mysterious. This is particularly true when a company is in a nascent industry, as dot-com companies were in the 1990s and social media companies are today.

To get some insight into how the company works and how the stock is valued, investors can look at the massive registration document required by the Securities and Exchange Commission for all new securities.

Known as Form S-1, or the Registration Statement Under the Securities Exchange Act of 1933, the offering document must contain specific information for investors, including financial information, the business model, risk factors and information about the industry. These documents can be found on the SEC's website, and they are normally loaded with caveats and disclaimers.

If investors can wade through the document, they can glean enough information about the new company to make a call about the valuation -- is it worth buying at the price people are selling?

Buying individual stocks requires a lot of homework, and they can be incredibly risky. Most individual investors should consider very new companies carefully, and experts recommend devoting no more than 2% of your portfolio to any one stock.

Like 1 IPO? Buy a Bunch

An alternative may be investing in one of a handful of mutual funds that invest in IPOs, such as Renaissance Capital's Global IPO Plus Aftermarket.

"We're really looking at investing in these companies that are not well-known yet by the market and that have an ability to get us gains very early in the price discovery," says Shelton Smith.

According to Morningstar, a couple of other prepackaged options are available to investors interested in IPOs, including a long/short fund from Direxion Funds and an IPO ETF from First Trust.

And in July, UBS launched a pair of exchange-traded notes focusing on Internet IPOs.

Ultimately, the way to get rich isn't with one successful investment, but by growing a diversified portfolio over time. Just ignore the fairy tales.