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Retail Investors Should Bide Time on IPOs

The initial public offering market has not been kind to retail investors over the past year. The year-to-date total return from the issue price is a drop of 5.7 percent against a decline of 1.3 percent for the Nasdaq Composite Index.

Most retail investors can't get in on these companies until they are trading publicly and by then the company has already seen its increase in value and the next step is down.

"The decline in the IPO market really goes back to 1998," said Tim Keating, CEO of Keating Capital. "Today about a third of all companies on Nasdaq don't have a single research analyst covering the stock."

This lack of coverage hurts after-market demand for stocks. Also, there are fewer underwriters since the financial crisis saw the end of Bear Stearns and Lehman Brothers, and led to consolidation throughout the industry.

"You've seen a dramatic shrinkage in the number of companies going public this year," said Keating.

Offerings this year experienced a drop of 19.9 percent from 2010 issuance.

Even Zynga's hotly anticipated IPO, which kicked off on Friday, has been greeted with some skepticism. Even before pricing its IPO on Thursday, for example, Sterne Agee analyst Arvind Bhatia was already panning the stock. Zynga's growth, he argued, is slowing faster than people think.

Many of the companies hitting the public market are owned by private equity firms. These firms often buy distressed public companies and take them private only to load them up with debt and roll them back out to public a few years later.

Deals like HCA Holdings or Delphi Automotive come to mind. The buyout firms are more concerned with cashing out for themselves and their limited partners than they are about how the company does once the IPO exit is complete.

Venture capital-backed deals can go either way. The venture firm may just be ready for a return on its investment but there are also many instances when the IPO is a way to take a company's development to the next level in terms of expansion.

The big danger for regular investors is getting sucked in by the media hype or brand recognition of the company. The average first-day pop for an IPO is a positive 11 percent, so it's easy to get up caught in the frenzy.

The worst IPOs for 2011 were some of the biggest.

HCA went public for a second time in March, raising $3.8 billion in the largest private equity-backed deal ever. Since its debut, the stock has lost 34 percent of its value and is the subject of a shareholder lawsuit. The suit accuses HCA of loading up the company with debt while private and then went public without telling shareholders the truth about its financial results and accounting.

Business social networker LinkedIn hit the market with lots of fanfare in late May. The company priced at $45 per share, and more than doubled on a volatile first day of trading to close at $94.25, running as high as $122.70 in the process.

The offering had plenty of appeal because retail buyers knew the company and probably even had a profile on the site.

Consumers like buying stocks that resonate with them. They feel that if they know the stock, that it should be a good deal. In addition, LinkedIn only offered a small percentage of the company's stock, driving up demand.

But as soon as they were able, insiders dumped the stock. The CEO sold 10 percent, Greylock Partners also sold 10 percent and the CFO sold 98,232 shares.

If the company is so great, why sell? Would you sell your Applestock? LinkedIn shares closed Thursday at $66.38, so anyone who bought in those first heady weeks of trading is down significantly.

Groupon is only down 15 percent from where it opened on its first day of trading, better than the previous two examples. The daily deal site has big brand recognition and investors flocked to the deal.

Even though Groupon ran into problems prior to the offering, it didn't stop the market from pricing the company as if it was already an established Internet giant like Amazon.

Groupon bragged about the growth it would have in the future and many new shareholders fell for the promises. Now even the underwriters are backing away from their former darling. Morgan Stanley only rates it an equal weight and suggests new buyers wait for a lower entry price.

They certainly didn't feel that way on opening day.

Dunkin Donuts priced its shares at $19 and immediately jumped to $27.85 on the first day of trading, when most retail investors finally had a chance to buy. That put the stock's valuation much higher than its rock solid peer McDonald's.

Shortly after completing the IPO, Dunkin reported a terrible second quarter with falling profits.

While new investors shouldn't have been surprised because the prospectus was clear about all the problems with the company, many investors don't have the time and patience to wade through these thick documents. They know the product and believe that if they see lines at their location — it must be a good company.

To make matters worse, the company followed on with a secondary offering, further diluting the shares.

So there's a healthy dose of cautionary tales that should have investors thinking twice about jumping in on Zynga. Chances are there will be a much better time to buy sometime next year.

Additional News: How to Get in On IPOs

Additional Views: Why Zynga's IPO Fell Flat

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Disclosures:

TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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AMZN
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APPL
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HCA
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LDKSY
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FMD
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MCD
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DELPHI AUTO
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DUNKIN
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GROUPON
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LINKEDIN
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ZYGNA
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