A question I get asked a lot is whether it makes more sense to sell shares of an IPO at the first-print opening price -- or to hang on and wait for the stock to presumably work higher over the course of the day.
My answer to this one is usually that I really don't know. But every time I field this question, I am forced to look at the current market and how the deals have been trading in their first sessions. What I am almost certain to find is that my inclination, whether it would be to flip on the open or to hold back, is wrong. This is my curse; I wear it like a chain around my neck.
What's interesting is that I spend much of my day gossiping with some very smart managers and traders with hedge funds and mutual funds. Rarely will a day go by without hearing at least one of them complain that they called an issue wrong and sold too soon -- only to watch in silent agony as the shares traded up another 10 or 20 points.
Or, even worse, that they held a sell ticket ready, but held off, thinking that the stock had more push left in it -- only to watch it get crushed by the crowd. During these conversations, I pour empathy into the phone, while in truth I think, "Ha! Too bad, smarty!" While I confess that it's really not nice to gloat over someone else's misery, it does makes me feel better to know that I am not the only one this happens to.
How do I cope with the realization that I will often get this decision wrong? My defense mechanism is simply to not look back. I sell, I take the symbol off my screen and I book the trade. I do not go back to stare at the machine, waiting for confirmation of what I already know is true. This spares me the pain of watching the market scoop up the money that I so carelessly left on the table.
This leads into my discussion of a game in which it is much easier to develop some rules for success: secondary offerings.
Since my first
Week Ahead in IPOs article, I have received literally dozens of emails asking me to explain secondary offerings, what they are and how they work. While not as exciting a topic as IPOs, it's clearly time to share with you my views on this often-misunderstood Wall Street phenomenon. So, here goes.
From time to time and for various reasons, additional shares of an already publicly traded company are floated on the public markets. When such stock is sold in an underwritten public offering, this is referred to as a secondary, or follow-on, offering. The two terms are interchangeable, but if you want to sound like a grizzled Street vet, use the latter.
There are at least two situations that can spawn a secondary stock offering. In most cases, either one or both of the following occurs:
- A publicly traded company wants to sell some number of its previously unissued shares in the public markets. We'll refer to these shares as "company shares."
- A shareholder or group of shareholders wants to sell shares of the company's stock in an underwritten public offering. We will refer to these as "holder shares."
When a public company is faced with the need to raise additional capital in the securities markets, it has two basic choices: borrowing money by issuing debt or selling additional stock. If a follow-on stock offering is determined to be the best course, the company will file to register a number of shares that it, along with the managing underwriter, feels is adequate to generate the desired amount of capital.
Assessing the Bailout Ratio
An offering may be made up entirely of company shares, holder shares or some combination of the two. One thing to consider when evaluating a secondary is the percentage of proceeds that are received by the company vs. the percentage received by selling shareholders.
The term used to describe this is the "bailout ratio," the extent to which the insiders are reducing their holdings in the company by trying to sell them to the public. Common wisdom dictates that a larger amount going to the company is a positive for the stock's performance.
Once the filing process is complete and the
Securities and Exchange Commission
is satisfied that a fair and full disclosure of the offering has been made, the underwriter or underwriters begin to market the stock via an offering circular, or prospectus. Orders for the stock are gathered from clients. These orders are not binding to either the underwriters or the clients until the deal has been declared effective by the SEC. Such orders are known as indications of interest, or IOIs, and make up what is known as the "book." The book is a running record of how many shares can be placed to investors, as indicated by the total of the IOIs, and how many remain to be sold. The book is the key measure of how a deal is being received by buyers and is often referred to in statements like: "The book looks good" or "How's the book?"
Once the deal is placed with investors, provided there are no problems with the SEC, the deal is priced and sold to those accounts that have entered IOIs for the stock. Pretty dry stuff so far, right? Well, hang on because this is where it gets good.
Is the Price Ever Right?
When underwriters set out to price a follow-on deal, they are charged with maintaining a very delicate balance, one in which the needs of both sides are in direct opposition. On the one hand, they must ensure that the investors who buy the shares are rewarded for taking the risk of owning the stock. On the other hand, they must maximize the proceeds to the selling parties: either the company, selling shareholders or both. How this balance is struck is based on many factors, none of which we will cover here. But, what it often comes down to is the underwriter's particular style of doing these transactions.
What a manager will sometimes do is price the follow-on at a discount to the previous day's closing price. This discount is passed on to the buyers and is their reward for buying the deal. In some cases, this discount can be significant and can result in an instant profit for the buyer.
In other cases, the stock will be priced right at the previous day's close, and the buyers receive no discount. Whether or not to discount a deal is completely up to the underwriter and the selling parties.
With respect to sales commissions on the shares, the seller pays these costs and the buyer pays only the price of the shares as determined to be the follow-on price.
Those are the nuts and bolts of a follow-on. So, how can you participate and make money? Well, as with any investment in stocks, there are no guarantees. But, there are some guidelines you can use to improve your chances of profiting from buying follow-on deals.
- Always read the prospectus. I know you hear this a lot, and I imagine that most of you ignore this advice. But if you don't do your homework and you lose money as a result, you get what you deserve. Harsh? Yes. But don't say I didn't warn you. (For more information, read
Andy Kessler's recent two-part series,
How to Read a Prospectus.)
Have a plan before you get involved in an offering. Determine why you are buying the stock -- whether for a long-term hold or for a quick flip. Establish your exit points for both price and time; know when you are getting out. Most important, stick to your plan.
Pay attention to the stock's price after an announced follow-on. Those stocks that move up in price after the follow-on offering is announced are more likely to result in profits than those issues that lose ground. Institutional investors and brokerage firms alike will quickly decide if a follow-on is a positive for an issue or a negative. Use the strength of the stock's price to tell you if the market likes a deal or hates it. You'll see this information highlighted for each secondary offering in every Monday's This Week in IPOs column.
Join me at 5 p.m. EDT tonight, May 6, on Yahoo! for a lively discussion on the IPO market, upcoming IPOs and how you can participate in what has become the hottest investment sector on Wall Street! Register for Yahoo! Chat at:
chat.yahoo.com. It's free!
Ben Holmes is the founder of ipoPros.com, a Boulder, Colo.-based research boutique specializing in the analysis of equity syndicate offerings. This column is not meant as investment advice; it is instead meant to provide insight into the methods of new and secondary offerings. Neither Holmes nor his firm has entered indications of interest in any of the companies discussed in this column. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Holmes appreciates your feedback at