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China Stock Fraud News Already Priced In

But herein lies two fundamental problems. For the average investor it is effectively impossible to get allocations in these deals, and even for institutions it is often very difficult to get an allocation large enough to "move the needle" for an institutional portfolio. Investors are stuck buying in the aftermarket, after the stock has spiked and investors are exposed to considerable downside risk.

This table illustrates the downside risk when buying into a hot IPO.

The second problem is one of valuation. Many of the recent IPO deals, particularly anything Internet-related, are priced at mindboggling valuations despite minimal profitability or even a lack of profitability.

As a result of these issues, I avoid playing newly minted IPOs and instead wait for them to season for a while (at least a few months) in the aftermarket when trading becomes more rational.

More often I focus on stocks that have been public for a few years and have a track record and an established reputation among investors. This applies both to IPO stocks and to RTO stocks.

Much attention has been given recently to the presence of fraud in RTO stocks compared to IPO stocks and I believe that concern is legitimate primarily because IPOs, especially the larger ones, have the involvement of established underwriters whereas RTOs typically don't. Large investment banks have the resources to conduct proper and thorough due diligence, and more importantly they have much more to lose in terms of reputation. As a result, the use of a large well-known underwriter is a key factor in weeding out fraud, although certainly not a guarantee.

While RTOs may be perceived as being inherently riskier than traditional IPOs, I believe that the fundamental investment decision-making process should be equally rigorous for both. In other words, just because a stock went public via a traditional IPO there is no excuse to not do a very thorough amount of homework when evaluating the stock.
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