Read This Before Investing In The Next Hot IPO

May 2, 2018

Read This Before Investing In The Next Hot IPO

Today, I’ll continue on with my review of Graham’s The Intelligent Investor with a discussion of the sixth chapter of the book.

Chapter 6 of The Intelligent Investor discusses:

  • Junk bonds
  • Foreign bonds
  • New stock issues – IPOs



Second Grade Bonds – Junk Bonds

This isn’t really a contemporary subject, but one to keep in mind for when bond opportunities arise.

Graham discusses how sometimes second grade bonds, or what we would now call high yield or junk bonds, trade at extreme discounts to their maturity value due to changes in interest rates and due to the change in the perception of risk. The junk bond yield has significantly increased over the past few months but is still far from opportunity territory as was the case in 2016, 2011, and especially 2009.

Figure 1: US junk bond yields. Source: FRED.



The current yield of 6.11% isn’t attractive at all when you see that in a scary moment, yields quickly jump to 10% and even to 20% in a recession. Therefore, now it isn’t the time to look at high yield bonds as investments. Wait for panic to do that and then choose wisely which is exactly what Graham prescribes for the enterprising investor. I quote: “A second-grade 5.5 or 6% bond selling at par is almost always a bad purchase. The same issue at 70 might make more sense – and if you are patient you will probably be able to buy it at those levels.”

Graham continues that nearly all junk bonds suffer severe sinking spells in bad markets but most of them recover when favorable conditions return. It’s crazy to think that nothing has changed in the bond market since 1971 and we still see the same patterns, but that is how the market works and we have to think about it now in order to take advantage of it later.

Foreign Bonds

Graham is completely against foreign bonds as he sees investing abroad as too risky because of all the things that can happen. Today, things might be different, but I agree with Graham and I wouldn’t touch foreign bonds in the current global low yield environment.

New Issues – Investing In IPOs

Graham’s message is to be wary of new issues.

There are two caveats when investing in new issues: they are sold in favorable market conditions, and special sales are needed to sell new stocks. He describes how new stock issues are many in bull markets but few in bear markets, and how the tragicomedy of new issues repeats itself often (1945,1960 and 1969). The tragicomedy continues to this day as the number of new issues are higher when the conditions are favorable to the issuer.

Figure 2: Number of IPOs per year since 1999. Source: Statista.



When the market circumstances are most favorable to those going public, the number of IPOs is extremely high. When those circumstances aren’t that favorable, IPO numbers are low.

Graham’s point with IPOs is that the enterprising investor should take advantage of IPOs in the early stages of the bull market as IPOs might be priced attractively to investors. Just think of Facebook in 2013. However, when small companies without anything special are offered at a premium to the general market based on a promise, it’s time to stay away from IPOs as there is a big chance for stock price declines. A perfect example of such a company is Snapchat which is still trading at 50% of its IPO launch.

Nevertheless, sometimes these new hot issues become hated by the market and again represent a bargain. Many Chinese stocks suffer a similar pattern with a boom at the IPO, but phase post-IPO and lock out only to see the stock surge as companies sometimes deploy the IPO cash really well.

I think that the current IPO environment isn’t as hot as it used to be as investors still feel the dot-com burns. However, IPOs represent opportunities when the environment is cool but there are many, many, many scams so one should really carefully assess each IPO opportunity and not fall for the nice words of the salesman promoting them. Always keep in mind that their fee is between 3 and 8% of what you are paying on an IPO.

Conclusion

The moral of the story is that in the stock market, nothing changes except the names, trends, and spectacular ups and downs over time. Let’s take advantage of those by being an intelligent investor.



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