The ‘Inside Baseball’ on IPOs

Initial public offerings can generate some spectacular returns – as high as 20%, 30% and 50% in a day – which makes them a great way to get back to even. That’s why Cramer devoted not one but two segments of Thursday’s Mad Money to these quick-money trades.

The thing is, there’s a lot of “inside baseball” details that investors need to know about IPOs before they buy them. Sure, there are the basics: Not everyone one is worth consideration, and these deals aren’t about luck. But did you also know that underwriters often underprice an offering just to attract interest?

It’s true. There are times when retail investors are sitting on the sidelines, and the underwriters try to draw them in. Why? Not only to help the soon-to-be-public company raise money, but also to keep their other clients, those who trade stocks, interested in the market. Because when the clients are buying and selling, the underwriters, who offer brokerage services as well, are making money on those transactions, too. So a well-priced IPO serves to get them back in the game.

Visa’s offering in March 2008 is a perfect example. Given the success of rival Mastercard’s IPO, the 41 investment banks and boutique brokerage houses that underwrote the Visa deal – the largest in US history – intentionally kept the price low at $44 a share. Investors rushed in to buy, and V popped as high as $69 once it hit the open market. Even after falling back to $56.40 at the close that day, Visa still delivered a 28% gain to anyone who got in on the deal.

A key part of Visa’s success was due to the “rationing process,” or the underwriters’ strict control of the stock supply. They parceled it out to clients who they knew wouldn’t immediately flip the stock for a profit. And they gave just enough to mutual funds to start their positions, leaving them to buy the rest in the aftermarket. That led to the furious bidding up of Visa that pushed it to $69.

It’s the syndicate desk that’s behind this rationing. They make sure there are as few flippers as possible, and they punish those who do by keeping them out of the next deal. Also, they tend to hold a number of shares handy for retail investors because these investors tend to hold stocks for the longer term.

One thing investors should never do, though, Cramer said, is buy in the aftermarket, which is buying an IPO’d stock once it’s available to the public. If you can’t get in the deal, forget about it. Otherwise you’ll just end up overpaying.

But how do you know which IPOs to buy and which to avoid? Click here for Cramer’s take on that.

Cramer's charitable trust owns Visa.

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