The flow of new companies prepared to trade their shares on the stock market and raise money from investors – known as an Initial Public Offering, or IPO – is widely viewed as a bellwether of market confidence. With every new company, investors have to weigh the upside opportunity against the risk of the unknown. They also have to take account of the intriguing patterns in the way shares in newly-listed companies typically perform, which is essential knowledge in any investor toolkit.
In May 2011, social network LinkedIn began trading in the US at $45 per share and closed the same day at more than twice the price. For the financial institutions that backed the company on its introduction, that performance cemented a widely-held view that IPOs have a tendency to be under-priced and, as such, you’d be mad to miss them (known as "the IPO effect").
As readers will know, we're rather keen on opportunities to exploit market inefficiencies, so what do we make of this one? Well, the trouble is that, as usual, there's more to it than the received wisdom would suggest. The headline-grabbing London IPOs of commodity trader Glencore and Russian gold producer Polymetal in 2011 produced muted first-day performances. Meanwhile, shares in food retailer Ocado immediately fell 12% on their introduction and took another five months to recover. At the smaller end of the market, the Alternative Investment Market IPOs of 3Legs Resources and Nandan Cleantec both achieved initial surges – but like their larger-listed IPO peers, the shares in those companies went on to produce very different performances in the months that followed.
How IPOs Work
Before exploring these trends further, it’s worth looking at how private investors can go about getting in on an IPO – because the answer to that has much to do with the way in which these deals are priced.
The rough guide to IPOs begins in the gleaming fortresses of City investment banks, which are hired by companies to handle the sale of their shares (presumably for as much as possible or whatever potential buyers can stomach). During these discussions the two sides will iron out whether the bank will buy the entire issue and then sell it on (underwrite) or whether they will simply get their broking team to shift as many shares as possible (best efforts). Friendly institutions will…
