Don’t Buy into the GM IPO Even If You Can

There’s been a lot of angst and gnashing of teeth in recent days about the likelihood that average investors will be shut out of GM’s forthcoming IPO. The very fact that this is newsworthy shows how little understanding there is in the media and among individual investors about how the IPO process works.

IPOs are universally viewed as the sexiest way to play the stock market. They’re also the riskiest, least understood and most fraught with hyperbole. Nonetheless, most individual investors would do pretty much anything to get a piece of the action -- even for a suspect post-bankruptcy company like GM -- and that’s a serious mistake.

An IPO refers to the process of a private company converting to a publicly traded company by selling stock to individual and institutional investors. IPO companies are usually younger and smaller companies in need of additional capital to expand. The less politically correct reason for an IPO is to pay back the venture capital firms and angel investors who supported the firm during its early years. Similarly, an IPO allows the companies’ founders to monetize their ownership stake. These are the folks who become instant millionaires on IPO day. The people who buy stock in the IPO are rarely as lucky.

Notwithstanding the speculative nature and relatively poor performance of IPO companies, investors excitedly line up to buy shares. Fortunately for them, most investors are excluded from the process. As explained on the Securities and Exchange web site (www.sec.gov), brokerage firms usually “sell the IPO only to selected clients. For example, before you can purchase an IPO, some firms require that you have a minimum cash balance in your account, are an active trader with the firm, or subscribe to one of their more expensive or ‘premium’ services.” This is a key point because it highlights the unwavering truth about IPOs: If the average investor is offered an opportunity to buy an IPO, it means that the smart money has declined -- and you should do the same.

That’s why most individual investors can’t participate in the GM IPO. It’s not part of a government conspiracy, and no valid argument can be made that this IPO should be different simply because the U.S. taxpayer bailed out GM. In truth, most retail investors would have no idea what exactly they’d be investing in other than the GM brand name (which has lost most of its former luster). I’d bet your right arm that the average investor who desperately wants a piece of the GM IPO wouldn’t be able to answer basic risk-management questions like what are GM’s normalized earnings, what is the firm’s global strategy, how will long-term pension funding requirements affect earnings, etc.

Anyone who’s still interested in buying the GM IPO is advised to remember this sage advice from Groucho Marx: “I don’t care to belong to any club that will have me as a member."

So if you can buy the GM IPO, don’t. If you can’t buy it, follow the stock in the weeks and months after the IPO, wait for the price to settle at fair value, and make a decision to buy or not based on logic and intellect rather than emotion and an artificial sense of urgency.

Article first published as Dont Buy into the GM IPO Even If You Can on Technorati.