The initial public offering of a company is an exciting time for management, employees, and investors. The ability for others to trade the shares is both thrilling and nerve-wracking. In the early period hopes are often high and the returns back it.
In general IPOs return positively the first year; with penny stocks this is especially true. But unless you can buy every single IPO that comes to the table this tactic won’t work well on its own. This is because the high volatility of penny stocks causes some IPOs to go ridiculously high the first year skewing the average.
There are things you can do to increase your chances of success with these initial public offerings though. Here are some tips for preparing for a penny stock IPO or for trading in one.
Watch for Shell Companies
One way people get hurt with initial public offerings is with a shell company. A shell company is a stock that has become worthless, but is never actually bankrupted. These companies can sit on the pink sheets trading occasionally, but they have no actual business they conduct anymore.
Sometimes a company that doesn’t meet the requirements for a true public offering will merge with one of these shell companies. They will tout this merger as an initial public offering to get the IPO hype going. This is not the same as a true offering and the returns are much more risky. A company that wants to work around this system likely won’t have shareholder interest in mind.
Look For Name Recognition
People love to invest in young companies with a name they know and recognize. The stories of Walmart have infiltrated every investment newsletter. People dream of 30% returns for decades. If a small company does a great job with brand recognition I would put a huge green check mark next to them for their IPO. The general population may jump in early in the rush for the new hot “safe” thing. I believe the known name adds a large margin of safety to your IPO play.
Look for Profit
Often new penny stock IPOs have never earned a real dollar. While their growth may be amazing their valuation is very speculative at best. When you find companies with a profit their earnings will support a price and often keep it from falling too far. This adds enough safety to your speculative trade to get your money back out if you feel it’s not working. There won’t be any sharp falls until the company has started to show steady losses.
Set a Stop Loss
Sometimes IPOs are set artificially low to generate interest. This interest gives an initial price jump which attracts other investors and traders. If you jump in on the IPO early and the price takes off, you need to be careful not to get too caught up in the moment. Have a moving stop loss set so you never lose too much off the peak. In the end you’ll be happier with your 30% return than owning a paper 1000% return, but watching it fall all the way back to break even.
Compare IPOs from Similar Underwriters
When a company goes public they hire underwriters to set the IPO, manage the auction, and determine proper pricing. Not all underwriters are created equally. Some set prices low just to knock the shares out quickly. Others will accept bribes from new companies to manipulate the initial offering to allow insiders to get out of their shares. Other underwriters just do a fantastic job.
Review the underwriter for the upcoming IPO and see what other companies they have helped. Look at their returns over the long haul and in the first couple of time periods. When you use this information with the other tips you’ll have a good feel of the price action that will happen in the first few weeks.