After two lean years, the market for initial public offerings (IPO) is back! Rock bottom short-term interest rates, quantitative easing parts 1 and 2, and unprecedented fiscal stimulus have all conspired to create an easy-money environment that is perfect for companies seeking to raise capital by launching an IPO. According to consulting firm PricewaterhouseCoopers, 154 companies have gone public in 2010, raising $37.5 billion. Compared to 2009, this represents a 123 percent increase in volume and 49 percent increase in value.

IPO Market is on Fire!

Furthermore, IPO activity appears to be accelerating. Just last week (Dec. 13-Dec. 17) there were eight IPOs. The IPO market in the fourth quarter of 2010 has not just recovered from the doldrums of the 2008-09 financial crisis, but has surpassed — with the help of General Motors (NYSE: GM) — the value levels for any quarter since the beginning of 2007. In terms of the number of IPO issuances, the 55 so far in Q4 2010 is the most since Q4 2007:

Don’t expect a slowdown anytime soon. With about 200 new IPO filings still in the pipeline, Pricewaterhouse expects “continued momentum in U.S. IPO market activity as we enter 2011.”

Top Performing IPOs of 2010

No doubt about it, investing in the right IPOs can produce huge profits. Take a look at 11 of the top-performing IPOs of 2010, each of which has appreciated by at least 100% since going public:

Source: Renaissance Capital

Of course, these are just the best performers and the return numbers include the first-day pop. Average investors never get to buy at the offering price; they have to wait until the shares start trading. For example, Youku.com – the YouTube of China – came public at $12.80 but it opened at $27 and closed its first day of trading at $33.44, a 161% increase from its offering price, the largest first-day pop since the 2005 IPO of Baidu.com (NasdaqGS: BIDU). Any investor who bought Youku.com at the open is up 18.5% — good, but nowhere near as good as the 150% gain noted in the table above. Even worse, anyone who waited until the close of Youku.com’s first day of trading to buy has actually lost money so far.

Plenty of IPOs lose money as well, so caution is definitely warranted. Among recent IPOs, the worst performers include 34% loser Mecox Lane (NasdaqGM: MCOX), 30% loser Sky-Mobi (NasdaqGM: MOBI), and 29% loser Bitauto Holdings (NYSE: BITA).

Criteria for Investing in IPOs

If you are determined to play the IPO game, you must spend the time to pick individual issues wisely. Your research should focus on the following five aspects:

1. Examine the quality of management. What is their background? Do they have substantial experience in the industry as well as a history of financial success? In an advisor roundtable from last April, I recounted one of my most painful investing lessons which involved buying a stock with a sexy technology but poor management.
2. Study the company’s pro forma financials, which are provided in the company’s S-1 registration statement filed with the Securities & Exchange Commission. The best IPOs typically are already profitable and growing.
   1. Money-losing companies typically go public out of desperation for cash needed to stay afloat, not because additional capital would allow them to exploit a multitude of profitable investment opportunities.
   2. Limit your purchases to larger companies with at least $50 million in annual sales. University of Florida finance professor Jay Ritter has found that IPOs of small companies with less than $50 million in annual sales “severely underperform” market averages whereas larger IPOs do not.
3. Be sensitive to valuation. Even the best companies can be overpriced, especially during periods of market euphoria. In such cases, it is better to wait a few weeks or months to buy in after the stock has (hopefully) had a chance to correct and decline to a more reasonable valuation level.
4. Check to see what the insiders and venture capitalists (VC) are doing. Are they selling a boatload of shares? If not, the IPO may be a bargain. For example, back in 2004 Google (NasdaqGS: GOOG) originally planned to sell shares in a price range of $108 to $135, but ended up selling shares at a much lower price of $85. Based on the lower price, Google CEO Eric Schmidt and co-founders Sergey Brin and Larry Page reduced their planned sales by half. VC firms Kleiner Perkins and Sequoia Capital, which had initially planned to sell more than 2 million shares each as part of the IPO, decided to sell none. This was a clear signal that the IPO price was undervalued and average investors should buy. Even though the stock opened at $100, it reached $200 by early November and $300 by June of the following year.
5. Watch out for the end of lock-up periods. Insiders are typically restricted from selling most of their shares until six months and 12 months after the IPO. Consequently, new investors should avoid purchasing shares near the dates when these lock-up periods end because insiders will be selling shares, which often causes the stock price to decline. For example, options exchange CBOE Holdings (NasdaqGS: CBOE), which went public this past June, has seen its share price decline in December as the six-month lockup expired on December 15^th, thus releasing 38 million shares from trading restrictions. The day after the lock-up period expired (Dec. 16^th), CBOE Holdings fell 3.6%.

Buying All IPOs is a Money-Losing Strategy

If buying individual IPOs is too much work and you are thinking about buying an IPO basket, keep in mind that most IPOs are losers. Wharton finance professor Jeremy Siegel, author of the investment classic The Future for Investors, wrote the following:

It is clear that buying IPOs, like buying lottery tickets, is a losing long-term strategy. Losing IPOs far outnumber the winners. Nearly four out of five newly issued firms have subsequently underperformed a representative small stock index. Of these, almost half have underperformed by more than 10 percent per year; more than one-third have underperformed by more than 20 percent per year, and almost 17 percent have underperformed by an astounding 30 percent per year or more.

In contrast, only one-fifth of the IPOs have outperformed the market. Less than 5 percent have done so by more than 10 percent per year, and only one-half of 1 percent have outperformed by more than 30 percent per year.

The fact that 80% of IPOs underperform is not surprising when you consider that most stocks underperform as well. In fact, Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the overall stock market; 75% of stocks underperformed.

Of course, if the winning IPOs win by large enough margins, an IPO basket could still come out ahead despite the majority of IPOs being losers. But Professor Siegel found that the winners don’t win by enough of a margin to bail out the losers. Between 1971 and 2003, an equally-weighted portfolio composed of all IPOs issued in a given year underperformed a small stock index in 29 of the 33 years measured.

IPO Investing Can Be Profitable If Indexed the Right Way!

But wait: this past July Renaissance Capital, an IPO research firm, issued a paper refuting much of Siegel’s research. Specifically, the paper argued that Siegel was measuring the IPO market improperly because he was using an equally-weighted portfolio rather than a market-cap-weighted portfolio. Since most stock market indices are market-cap weighted, so should any IPO index. When one measures IPO performance based on a market-cap-weighted basis, it outperforms the S&P 500. This conclusion meshes well with the research of professor Jay Ritter discussed above because it eliminates the influence of the small IPOs which severely underperform.

I could only find two investment vehicles for playing the IPO market — an actively-managed mutual fund run by Renaissance Capital called IPO Plus Aftermarket (IPOSX) and a passive ETF called First Trust IPOX-100 Index Fund (NYSE: FPX), which focuses on the 100 largest market-cap IPOs. Since 2006, the actively-managed mutual fund has underperformed the S&P 500 by more than 16% whereas the ETF has outperformed by almost 13%:

Source: Bloomberg

Bottom line: either be very selective in your purchase of individual IPOs or buy the IPO ETF. Avoid the actively-managed IPO mutual fund.