Markets

Want To Buy An IPO Like Lyft? Here's Why That's A Bad Idea

In case any investor needed a reminder about the importance of value, we can look at Lyft's initial public offering.

Last Friday, Lyft began trading to great fanfare. It opened significantly higher that day, delivering large gains to some of Wall Street's biggest investors. That's how IPOs often work.

How IPOs Work
In an IPO, in general, we can say that the company sells shares to Wall Street. Specifically, early investors in the company and insiders are selling shares to large Wall Street firms. The sellers are doing so, at least in part, because they want to cash out. This indicates the company is potentially overvalued.

Initial buyers of the stock receive their shares after the close the day before the stock begins trading. They are large customers of the firms handling the IPO. There are two reasons for that...

One is simply efficiency. It's easier to allocate shares to buyers asking for hundreds of thousands of shares than to individuals asking for less than 100 shares.

The second reason is based on the fact that the share price is expected to rise when trading starts. Investors who got their shares the day before will enjoy an immediate gain. The firms allocating the initial shares will therefore use shares to reward their best customers.

So, when trading begins, we have a situation that favors large investors. But for some reason, at least some individual investors buy shares that first day. The result is quite often a loss. It's almost as if the big players on Wall Street are profiting from the naivety of smaller investors...

That explains what we saw in Lyft (Nasdaq: LYFT).

LYFT chart

Source: Yahoo

It also explains what we have seen in many other IPOs, as the next chart shows.

IPO performance table

Source: The New York Times

Here's the reality most investors need to understand: The big gains reported for IPOs generally aren't available to individual investors. Etsy (Nasdaq: ETSY), for example, reported a gain of 93.8% on the first day of trading. But if you bought the open, you lost 3.2%.

Action To Take
This problem is easy to solve. Don't buy IPOs until the stock builds up a track record and you can base a decision on what the stock has done, instead of what management and Wall Street analysts expect the stock to do.

We are likely to see a number of IPOs in the next few months and I'll be ignoring all of them, looking for safe trades like the ones we make over at my premium newsletter, Income Trader.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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