Research IPOs carefully to avoid getting burned

July 25, 1993|By Thomas Watterson | Thomas Watterson,Boston Globe

Last year the market for initial public offerings was hot. This year it's even hotter -- 289 IPOs, worth $26.4 billion in the first six months of 1993 -- which means investors are even more likely to get burned.

Consider the case of S3 Inc., which went public in March at $15 a share. It offers a new reason why the IPO business is, if not rigged, at least skewed against the ordinary investor.

This month, a few big shareholders may have been selling S3 stock. Normally, investors close to the company -- executives and employees -- are barred from selling shares earlier than the original "lockup" date. In S3's case, that was supposed to be Sept. 2.

But as the Wall Street Journal reports, Lehman Brothers, the lead underwriter, told these investors in a private letter they could sell as much as a third of their holdings beginning July 13. That letter seems to explain why S3 stock fell 5 percent, on four times its normal volume on the 13th. The stock already had dropped 15 percent in the previous week, suggesting that some investors knew the letter was coming.

While the company says the possibility of an "early release" of the lockup was described in the prospectus, it does not say there will be any public announcement of the release.

Where does this leave ordinary investors, who have come to expect that stock prices reflect public information or, at the very least, educated guesses about information that might be made public in the future?

The S3 case seems to say the rules can change in the middle of the game. And it provides another reason for investors to treat IPOs with great care.

"The IPO market is a very difficult market," said John Ballen, portfolio manager of the MFS Lifetime Emerging Growth Fund in Boston. "It requires a tremendous amount of expertise and time." As much as 15 percent of Mr. Ballen's portfolio is invested in IPOs, he says, and he might look at 1,000 new issues before buying 10.

Weighing the risks

One that he did not buy was Levitz Furniture. The company, which went public at the beginning of this month, "is a great brand name and a great concept," Mr. Ballen says. "But it's a highly leveraged company in a very cyclical industry."

During the offering period, he recalls, the underwriters were projecting that comparable-store sales at Levitz would increase 7 percent to 10 percent a year.

"That seems like an aggressive assumption," he says.

"Each 1 percent change in comp-store sales would mean a difference of 5 cents in earnings." So if the underwriters' estimates were off by just 2 percent, that would mean 10 cents a share less earnings. With that much risk, Mr. Ballen passed.

Portfolio managers and other institutional investors have an advantage that ordinary investors lack: access. "We spend time with management, we talk with customers and suppliers," says Charles Glovsky, portfolio manager for small capitalization funds State Street Research and Management Co. in Boston. "We go way beyond what the management tells us."

The rest of us must rely on the sales pitch from a broker, reports from the underwriter and the prospectus, which may or may not be comprehensible.

Some IPOs seem like good prospects, Mr. Glovsky says, but they may be overpriced, and the market has given them a chilly reception. In some cases, he says, institutional buyers may be able to set the price. "They might be asking $15 or $16, but we'll offer $10 or $11 for 10 percent of the issue. Sometimes they'll go for it," he says.

If portfolio managers such as Mr. Ballen and Mr. Glovsky are rejecting hundreds of IPOs for every one they buy, what happens to all those issues they and others discard? Those are turned over to the retail side of the business, where brokers try to sell them to the public.

Lynn Hopewell, a Virginia-based financial planner, said: "Look who's making money on these things. It's the underwriters and the sponsors." He says IPOs should only be considered by people who have the time to do the research, the temperament to handle the volatility and enough money to withstand the losses.

Sharpen your edge

Should everyone else avoid all IPOs? Maybe not. For starters, let's say you know something about the company or the business; for example, you work in a company that makes stationery supplies and you're filling a lot of orders for Office Depot. Or, you work in a hospital where you've seen a recently approved drug heal patients, and the company that made it is going public.

That's a start. Now, read all the pre-offering documents you can get your hands on, including the prospectus. If you know an accountant who can help you review the company's balance sheet, that will help, too. The prospectus should give you a detailed account of the company's history, lines of business, competition, lawsuits and other factors that might add to the risk.

Also find out just how many products the company is actually selling. Some IPOs in biotechnology, for example, have been rolled out based on nothing more than an expectation of government approval for one new drug. But if the drug isn't approved, or if it turns out to be not that different from something else already on the market, the stock price can collapse very fast.

Also, find out if there's an early release date that allows insiders to sell before the original lockup date. If there is, and you can't get assurances the release will be announced, don't buy.

Finally, make sure you're only using a small portion of your money, less than 5 percent. And if you're letting a broker make trades for you, make sure any IPO purchases are approved by you in advance. There should be a letter on file with the brokerage office spelling this out.

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