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IPO experts explain why it's dangerous to hop onto red-hot stocks like Beyond Meat - and share their best advice for regular investors

Business Insider | Jun 21, 2019, 11.32PM IST

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  • There's been an IPO frenzy in 2019 with companies like Lyft, Uber, Chewy, and Beyond Meat listing on public markets.
  • Some stocks like Beyond Meat have seen huge increases in share price as they've captured eyes and dollars on the Street.
  • Experts say that individual investors should proceed with caution when considering buying IPOs, however.
  • Read more on Markets Insider.

It's been a big year for initial public offerings. Noteworthy companies such as Lyft, Uber, and Chewy have all rushed to the public market. In addition, big gainers like Beyond Meat - up as much as 600% since its debut - have captured the attention of investors.

But there are a few things to keep in mind before investing in an IPO, even if it seems like the newest hot stock on the Street.

"'Hot' is a short term view - you want to pick something for the long term," said John Jacobs, executive director of the Georgetown Center for Financial Markets and Policy and former chief marketing officer of Nasdaq.

Know who you're buying from

When companies are looking to list on a public marketplace, they first do a roadshow with investment banks to sell shares - this is the primary market. These Wall Street insiders look at the company, its performance, market share, leadership, and plan for the future and determine an initial share price. Then, when the company lists on the public exchange, those initial holders of the stock sell to other investors on a secondary market.

"It means you're not getting the best price," Jacobs said. "It's always a risk to buy an IPO because you know less than the insiders. You're buying it from people wanting to get out of the deal."

To be sure, not everyone who could sell after a company IPOs is an investment banker looking to turn a profit. Some are investors who have been with the company for years and are looking to capitalize on their long-term holding. And for a stock like Beyond Meat that has surged more than 600% from its initial price within a few weeks, it's easy to see why early investors would want to sell and take earnings.

The problem, Jacobs said, is that when the first investors - investment bankers - do sell, the shareholder base shifts from people who really know the company to those who might not, and who definitely do not have the same level of access that investment bankers have.

That can cause issues because new shareholders' expectations for the stock can be out of whack: If they expect it to continue to go up astronomically, they could be disappointed.

What can impact price after IPO

"How do you know if you're getting it at an attractive price to realize return on your investment?" said Kathleen Smith, principal at Renaissance Capital, which provides IPO-focused exchange-traded funds.

The price of stock can be influenced by many different things after an IPO, aside from company performance or underlying fundamentals. Big jumps - or even drops - in price aren't necessarily indicators of future performance but instead express investor sentiment. For example, some of Beyond Meat's huge gains in the first weeks of trading can be attributed to things that the company doesn't necessarily control, such as being the first-to-market company in plant-based meat, a trend with huge demand and little supply in the market.

Shares of Tilray, the first cannabis company to list on the public market, had a similar trajectory at first, Smith said. Tilray spiked more than 1,000% in the first two months of trading, soaring to $214 per share from $17. But it's since dropped and settled around $48 per share.

"When they run up like this, you get these really big drops along the way until it settles into its right price," she said. Before a stock settles into that price, it can be difficult to gauge entry and exit points that make financial sense.

How to invest in IPOs

So what metrics should an investor look at when deciding if an IPO is worth buying?

Jacobs recommends doing your research on the market that the listing company is going after to distinguish a trend from a fad. Then, he said, it's important to look at senior leadership, the plan they present for future growth, and the ability and capability they have to execute that plan.

After doing your research, consider your time horizon, Jacobs said. You should look for companies that you believe in and want to hold long term. If an investor had bought Amazon early on, they would've been initially disappointed. But if they'd held onto the stock through the years, they would have made a fortune.

Smith also recommends looking for an ETF that tracks IPOs, which Renaissance Capital offers. This gives investors exposure to the gains of IPOs while hedging some of the risk of determining the correct entry and exit points, she said. The Renaissance IPO ETF holds the largest, most liquid IPOs of the last 2 years, selected by market cap and weighted by tradable shares, she said.

It rebalanced Friday, adding a few big-name IPOs including Beyond Meat, Chewy and Levi Strauss & Co. In addition, Uber, Pinterest, and Zoom are in the portfolio.

"Those have given us strong performance because investors are very interested in growth companies right now," Smith said. Although investing in IPOs can be tricky, there is an upside - the kind of growth seen in an IPO can be difficult to find in the wider market now that it's in a slow-growth economy, she said.

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