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How the Individual Investor Can Cash in on IPOs

Thomas J is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A calamitous June ended Friday with an exclamatory punctuation that saw all major American indices close up better than two and a half percent as Germany kind of sort of agreed to a bailout of its beleaguered EU colleagues. Stocks catapulted to the best June in 10 years even as German finance minister Schaeuble attempted to temper market enthusiasm by reinforcing Merkel’s “As long as I live there will be no Eurobonds” stance.

Amidst the onslaught of economic glee, an IT assistance software company named Service Now (NYSE: NOW) coincidentally launched its IPO. The rosy Euro news, combined with an IPO market incredibly action-deprived since the Facebook (NASDAQ: FB) fiasco, stuffed ServiceNow into a cannon and careened shares to close 36% above the offer price. Market pundits jumped for joy, the IPO had made its valiant return! As a retail investor kicking dirt in the dugout, I can’t say that I agree.

One of my best friends was married this past weekend and at the rehearsal dinner I had a lengthy conversation with a man who has worked in investment banking for 30 years at the most prestigious banks in the country. I was shocked to learn that he doesn’t invest in IPOs when he isn’t on the ground floor. He said the uncertainty is far too high. If he doesn’t have faith in the process, how is a retail investor with $1,500 in his Scottrade account supposed to?

Mark Cuban wrote a great piece on his blog about how the Facebook botch chased the retail investor away possibly forever. In a novel and noble attempt to be true to the company’s mantra of putting its social network above corporate profits, Facebook attempted to get mom-and-pop investors into the IPO fold. On that fateful Friday, Morgan Stanley (NYSE: MS) frantically gobbled up open market shares to prop up the stock in order to ensure it closed above the inflated IPO valuation. If Johnny Retail was able to battle through a host of opening day issues and grab some shares for the market close the day of the IPO, he saw his investment deteriorate 11% by the following Monday’s close. It got worse from there.

Outside of Facebook, it is incredibly difficult or near impossible for the retail investor to cash in on the initial offering bump that occurs milliseconds after companies are ushered onto the exchange. Historical IPO data of the past few years shows that stocks often give up their initial bump, opening up the opportunity to purchase at a lower price or short when possible. It isn’t a guarantee that companies can be shorted directly following an IPO, because the order requires one of the underwriters to loan out shares to be sold and repurchased later hopefully at a lower price.

Sticking with the Facebook example for a moment, Morgan Stanley followed secondary underwriters Goldman Sachs (NYSE: GS) and JPMorgan (NYSE: JPM) into the FB short sale business on June 5. In a suspicious coincidence, that day just so happened to be the lowest close to date (hmm…).

Let’s grind some tickers. 

<img src="/media/images/user_60/ipo-picture_large.png" />

Assuming it was possible to short all of these blockbuster IPOs, Johnny Retail would be able to capture some pretty solid returns by shorting the day of the offering and some massive gains from shorting at their peaks.

Without knowing much about ServiceNow’s business, it is certainly possible that this IPO balloon will deflate in a similar fashion. It is worth noting that the company is already making money, netting $9.8MM for FY2011 versus a loss of more than $38MM a year prior. It also operates in the growing cloud computing industry and has enjoyed tremendous revenue growth. ServiceNow's promising business case would only underline the effectiveness of this IPO shorting strategy if it were to give up its gains.  It will be interesting to see how the company’s valuation holds up on the open market. I intend to track this stock in the coming weeks to see how it fares as the hangover from the IPO party sets in.


Tom Lavan owns shares of Splunk. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

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