Four secrets to purchase an IPO

"Don't believe hype". The saying is known from Public Enemy, but in reality could fit for investor considering buying in an IPO. At the Tycoon Report, Louis Basenese even says that that's the "perfect motto" in the IPO market. The article exploits recent tricks which investors can fall, including the ones that happened with tech companies like Facebook or Groupon.

I've spilled considerable ink trashing a handful of upcoming initial public offerings (IPOs). The most notable ones being daily deals company, Groupon, and social networking juggernaut, Facebook. In fairness, though, the fundamentals warrant it.

However, while Wall Street and the media like nothing more than to jump on the latest hot stock market offering and whip the masses into a frenzy, not all IPOs are created equal. There's plenty of money up for grabs from this market. But to do it, you must follow two rules:


Rule #1: Don't Believe the Hype:

I've found that the most hyped IPOs tend to be terrible investments. Why? Because prices run up too far, too fast, before everyday investors have a chance to buy shares. Sadly, the only ones able to book profits are insiders - hedge funds, mutual funds and ultra-high net worth investors - that were fortunate enough to get an initial allocation.

But all hope isn't lost. IPO riches are attainable. Which brings me to Rule #2...


Rule #2: Know the Signs That Indicate An IPO Has Investment Merit:

Once we shun the overhyped deals, we can instead focus on fundamentally sound, fast-growing, under-the-radar IPOs.

That's what I'll show you in this article: How to separate the IPO contenders from the pretenders.

"More millionaires have been made in the IPO market than in any other segment of the stock market." So says financial author, David Menlow.
That's undoubtedly true if you look at the first-day IPO gains that some companies have enjoyed. For example...

• Online travel company, Priceline.com (NASDAQ: PCLN), blasted 331% higher on its March 31, 1999 stock market debut.
• Chinese internet search company, Baidu, Inc. (NASDAQ: BIDu), rocketed by 354% on its first day of trading on August 4, 2005.
• Chipotle Mexican Grill (NYSE: CMG) notched a 100% first-day gain on January 25, 2006.
• More recently, the heavily hyped business networking firm, LinkedIn (NYSE: LNKD), bounced by 109% when it launched on May 19, 2011.

Stellar gains, for sure.

That being said, many investors are hesitant to invest in the IPO market today. Here's why they're missing out - and how you can claim your share of the outstanding profits on from this misunderstood market...

The IPO Market: Like Ibuprofen for Economic Pain

The current doom-and-gloom over high unemployment, the perpetually depressed housing market and a stagnant overall economy has created furious stock market volatility. As a result, both would-be IPO companies and investors have backed away from the IPO market.

But know this: The IPO market is one of the best places to invest following a recession. And the profit potential increases if the slump is prolonged, like we're experiencing today.

Take the recession of 1973 to 1975, for example. Like today, the period also featured high unemployment and war. But as the United States emerged from it, the IPO market heated up. From 1975 to 1979, IPO stocks returned an average 34% gain per year for investors - four times better than the Dow's performance.

The truth is, companies with viable, sustainable business models not only enjoyed strong stock market debuts, they've also stood the test of time and have prospered ever since.

For example, athenahealth, Inc. (NASDAQ: ATHN) posted a 97% return on its first day of trading and now sits some 261% higher than its original offer price of $18. And Under Armour, Inc. (NYSE: UA) was originally offered at $13 and notched a 95% first-day gain. It now trades around $70 - 438% higher than its IPO price.

This debunks a common misconception among investors: That IPO gains are only reserved for a privileged few preferred investors (company executives, hedge funds and institutions). It's not true.

So how do you profit from IPOs?

Let's run down a few key characteristics of a strong IPO...

The Top Four Ways to Spot A Hot IPO

1. Long-Term Growth Potential: When you invest in an IPO, you're investing in the future growth of that company. So it stands to reason that if you jump on a company in the early stages of a significant, long-term growth cycle, you can scoop handsome profits before the crowd catches on. Go for companies in markets that offer 10 years of growth potential.
    
2. Two Years of Profitability: Remember the old stock market adage: Share prices follow earnings. Most IPOs that fail after their stock market launch do so because they lack earnings. But if a company is growing the bottom line, the share price is likely to follow. Roughly 75% of IPOs during the dot-com days couldn't make the "profitability" claim... and they ended up on the trash heap.
   
   So insist on at least one to two years of profitable operations and you're more likely to avoid stepping on an IPO landmine.
    
3. $50 Million-Plus in Annual Revenue: Just as share prices follow earnings, they also follow revenue, according to University of Florida research. The key question is whether a company had sales of $50 million in the year prior to going public. Those that did rose by an average of almost 40% over the following three years. The companies that weren't above the $50 million threshold only posted a 5% return over the same period.
    
4. Age: Make sure a company has existed long enough and has demonstrated its long-term viability by the time it hits the stock market. Why? Because the older and more established a company is when it goes public, the better its shares tend to perform. Such proven viability isn't something you could say about most IPOs during the dot-com collapse. The average IPO back then hit the market at just four to five years of age.

Essentially, when you're investing in IPOs, follow the same rules as you would for other stocks. Namely, that fundamentals ultimately drive share prices. So use the guidelines above. The stronger the fundamentals, the greater the profit potential.

In addition, look for companies that intend to use IPO money for upgrading or expanding the business, rather than just lining the pockets of the executives and preferred investors. This helps filter out the overly hyped, more speculative offerings and, instead, places the focus on robust, long-term fundamentals.