How And When To Know Which IPOs To Invest In

by: Brian Nichols

High profile IPOs are typically a no-win situation for all who buy the day of its IPO. These stocks are usually priced much higher than earnings and trade on speculation rather than fundamentals. Yet big gains from high profile stocks such as Linkedin (LNKD) has created optimism among investors, along with a perception that IPOs will provide immediate gains. However, I have suggested, for quite some time, an alternative way to play IPOs which have produced large gains for each stock that meets its criteria. With this last week being one of the best weeks in years for IPOs, I will better discuss this trend and explain which stocks you should watch so that you can capitalize on gains in the future.

First, let's look at both Groupon (NASDAQ:GRPN) and Angie's List (NASDAQ:ANGI) which were two high profile, yet speculative IPOs that I consider to be internet companies. The label of an internet company is crucial to the trend that I will discuss, because these companies trade with a high level of speculation. Stocks such as Groupon and Angie's List remind us of the dotcom era, when there were so many companies that filed for IPOs and traded publicly, only to file for bankruptcy a few years later. Therefore investors are hesitant to invest large sums of money in speculative companies since we simply don't know if the business model will provide long-term growth or if the company's only a fad. Internet companies are difficult to value, because we don't know if we're buying the next Facebook or the next Myspace. Therefore we trade these companies with a grain of salt and buy or sell to capitalize on trends and immediate gains rather than long-term growth. Both Angie's List and Groupon fall in this category, and are highly speculative, yet both stocks performed very well during the day of their IPO. Investors were attempting to capitalize on IPO gains which have occurred so often in the past, with stocks such as LinkedIn.

During the first half of 2011 there were several speculative internet companies to file for an IPO and trade very high during their first day of trading. Stocks such as LinkedIn posted very large gains the day of the IPO, only to fall during the following days. This trend continued for quite some time, but has recently changed with IPOs such as Groupon, Angie's List, Jive (NASDAQ:JIVE), and Zynga (NASDAQ:ZNGA). Each of these stocks opened near the IPOs high price on the day of the IPO, and then either maintained the price or trended lower throughout the day. Therefore, investors who purchased these stocks when they began trading didn't return gains, since the stock opened at such a high premium to its IPO price. During the last few high profile IPOs, investors who bought shares when they began trading, lost money. In the case of Zynga, investors lost a large sum of money when the stock opened with a 10% gain only to close with a 5% loss.

IPOs are no longer providing the large gains that we experienced during the first half of 2011. So the question becomes, how to play the IPO market? We've already established that you can't make money during a stock's IPO because it usually begins trading at its highest price of the day. Therefore I suggest a trend that I've been playing for the last three months, and that I've noticed in each of the last 10 high profile internet company IPOs. I first mentioned this trend with Groupon and wrote an article on November 28 to inform investors of the trend and explain why it was about to occur. From the time that I first called the trend until the time I acknowledged it was complete, the stock gained nearly 50%.

I believe this is a very simple trend to identify along with being simple to explain. To better explain the trend, I've included four charts of the more high-profile IPOs of the last year below. I ask that you observe the charts and then read as I explain the trend which has occurred in each of the last 10 high profile internet stocks.

Chart forLinkedIn Corporation (LNKD)

Chart forZillow, Inc. (NASDAQ:<a href='' title='Zillow Group, Inc.'>Z</a>)

Chart forGroupon, Inc. (<a href='' title='Groupon, Inc.'>GRPN</a>)

Chart forAngie

The four charts above show a trend in which I've described on several occasions among high profile internet stocks. Each stock shows the same trend: A significant loss in value following the IPO, only to post very large gains after the stock posted its initial loss. It's a very calculated trend with a loss of more than 40%, from a stock's high, and then gains of at least 30% once the stock reverses. To read more regarding the technical play of this trend and how to capitalize on it click here. However, the question remains, which stocks will trade with this particular pattern?

We've already discussed high profile, internet-based companies and the high volatility within their stock. However, there is another type of IPO; and that is companies that are established and have physical locations. These companies typically trade with lower valuations, compared to fundamentals, and have less chance of failure as a long-term investment. As a result, these companies do not follow the same trend as the high profile IPOs that I've mentioned above. The recent IPO Michael Kors (NYSE:KORS) will not follow this trend because it's a retail company and lacks the same level of skepticism as a company such as Zynga, which could be a fad. The same reason that stocks such as LinkedIn, Pandora (NYSE:P), Zillow (Z), Renren (NYSE:RENN), etc. followed this trend is the same reasons that stocks such as KORS, GNC (NYSE:GNC), and Dunkin' Brands (NASDAQ:DNKN) won't.

In my opinion, high profile, internet-based companies that become publicly traded follow this trend because of the skepticism among investors. As I said, it's unknown if the internet-based company will become the next Facebook or the next Myspace. And because of the high number of public companies to file for bankruptcy during the dotcom era, investors are naturally pessimistic regarding an investment in these companies long-term. Yet during the last year, investors would buy a stock during its IPO, regardless of how the investor felt about the company's long-term potential. Then after returning quick gains, the bearish investors would sell and cause a domino effect among other investors who were trying to protect their gains or limit losses. I believe that when this occurs, it then pushes the stock low enough to where investors feel comfortable in buying the stock, which then causes another domino effect of investors attempting to capitalize on the stock's trend higher. Of course this is speculative and is my psychological reasoning for why this occurs. However no one really knows why this occurs. All I know is that it does occur, and that it doesn't occur in stocks of established companies with a better chance of sustained growth and long-term success.

Rather than breaking down every single IPO over the last year, I ask that you perform the due diligence and look at the charts yourself. The trends aren't difficult to recognize and once you've seen the pattern you can capitalize on the gains that these high profile, internet-based stocks will return.

I will conclude with two charts that include 20 total stocks. The first chart will show several companies that filed for their IPO during the last year. Each of these companies were high profile and followed the same trend of loss within two months and then reversed to post large gains of more than 30%. The second chart includes established companies with physical locations that filed for an IPO during the last year. After looking at the stocks, within both charts you will notice that each of the stocks in the first chart follow this trend, however, the stocks in the second chart do not. Rather, they trade off fundamental progress.

I believe this is the most effective way to explain which stocks are best to purchase after its IPO. Because the last thing you want is to buy a stock, such as the ones in the second chart, and not capitalize on this trend and the gains that it provides. And I think that after you take the time and look at the stocks within both charts you will have a better idea of this trend and just how common the trend is within high profile, internet-based stocks.

High Profile Internet Based Companies

Groupon (GRPN)
Angie's List (ANGI)
Zillow (Z)
Linkedin (LNKD)
Demand Media (DMD)
Renren (RENN)
Pandora (P) (NASDAQ:TUDO)

Established Companies With Physical Locations

Zipcap (ZIP)
Spirit Airlines (NASDAQ:SAVE)
Pacira Pharma. (NASDAQ:PCRX)
Fusion-IO (NYSE:FIO)
Sagent Pharma. (NASDAQ:SGNT)
Endocyte (NASDAQ:ECYT)
Dunkin' Brands (DNKN)
GNC Holdings (GNC)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.