Warning: Ipo Mania Can Be Costly

By THOMAS McCARROLL

Mutual funds are not the only red-hot investments these days. Initial public offerings have been equally incendiary. Like mutual funds, IPOs have been an attractive market for investors -- if they can avoid getting burned. For instance, weeks before MathSoft sold its stock to the public for the first time, eager investors lined up to get a piece of the action. Lured by brokers' pitches and a prospectus that touted the computer-software producer's growth potential, customers quickly snapped up the company's 2.5 million shares at $13 each when the issue began trading in February. After a brief run-up to $21.50 on its first day of trading, MathSoft shares short-circuited, falling 76% to the current price of $5.13. Particularly galling to these new shareholders was the report that five insiders, including president David Blohm, had already bailed out, selling more than 384,000 shares after the first week of trading at prices averaging around $13.

"The lesson for small investors is crystal clear," says John Markese, president of the American Association of Individual Investors. "The average Joe or Jane should stay as far away from IPOs as possible."

Warnings notwithstanding, small investors are sticking out their financial neck. Individual investors, who used to avoid the new-issues market because of its high risks and arcane mechanics, have suddenly taken to gobbling up initial public offerings. So far this year, there have been 539 IPOs, compared with 433 during the same nine-month period in 1992, itself a record year. The value of these new issues -- nearly $30 billion -- is 50% ahead of last year's pace.

In the largest public offering of an American company, insurance giant Allstate raised $2.1 billion in June, selling 79 million shares at $27 each. Allstate, which jumped as high as $33 a share, is now trading around $31. Iwerks Entertainment, a Burbank, California, start-up that produces specialty theaters for 3-D movies, sold $100 million worth of stock last month. Issued at $18 a share, Iwerks soared 15.5 points on its first day of trading. It closed at $34.50 last week. Other high-flying IPOs include General Nutrition Companies, a chain of health-food stores whose stock has soared 228% since going public at $16 in January, and Barnes & Noble, a big book retailer that is trading at $30, up 50% since coming to market in September. An additional 172 IPOs are scheduled to hit the market this year.

With rates on certificates of deposit dropping to their lowest levels ever and stocks at near record highs, IPOs look irresistible. They tend to outperform the market, at least in the beginning. The payback on this year's IPOs has hovered around 30%, compared with 5.3% for the Standard & Poor's index of 500 stocks. IPOs also give investors an opportunity to get in on the ground floor of what might be the next Apple Computer or Microsoft. But for every Microsoft, there are five flops, like MathSoft. And that's what makes market watchers nervous.

Analysts warn that the quality of firms going public is likely to decline the longer the IPOfest lasts. In a correction, these weaker issues would fall faster and harder than the general market. "A strong market opens the window for butterflies and hummingbirds," says Charles Ronson, a New York City stock analyst who publishes the newsletter IPO Value Monitor. "But it also lets in the houseflies and spiders."

The trick for investors is to separate the best from the pests. A study by the Jefferson Group tracking the 3,186 companies that went public during the 1980s found that investors had only a 1-in-3 chance of making money in IPOs. While the stock prices rose for a third of the firms, they fell for a quarter of them. About 42% of the concerns failed or merged by the end of the decade. In a four-year study of about 900 initial public offerings, Cornell University finance professor Roni Michaely discovered that IPOs generally outperform the rest of the market for only the first six to nine months but then start lagging behind. After two years, IPOs were typically underperforming the S&P by 20%. Michaely explains that IPO prices are usually propped up by their lead underwriters in the early stages with positive reports known as "booster shots." But these shots also tend to coincide with heavy selling by insiders. "The buyer, or the sucker," he says, "is usually the small investor."

Perhaps the biggest problem for investors is getting in on the action in the first place. Brokerage firms tend to share prize IPOs only with their favorite clients, mainly big institutions and frequent customers, leaving small investors with the leftovers. Although stock exchanges have rules to discourage hoarding of hot issues, Wall Street firms generally interpret the guidelines to squeeze out the public. Some companies even instruct their brokers not sell IPOs to new customers. "It has nothing to do with fairness," says Joseph Plumeri, president of Smith Barney Shearson. "Is it fair to have a frequent-flyer pro gram where infrequent flyers can upgrade to first class just like regular customers?"

Despite the roadblocks and potential land mines, adventurous investors can find IPOs to be rewarding, provided they step carefully. The prospectus should be studied in detail. Investors should check out the industry as a whole as well as the company's management and history. As a rule, firms less than five years old ought to be avoided, IPOs should be a small part of a portfolio, and investors should be prepared to hold for the long term. And watch out for spiders.

CHART: NOT AVAILABLE

CREDIT: TIME Graphic by Steve Hart

[TMFONT 1 d #666666 d {Source: Securities Data Co.}]CAPTION: IPOs CAN SOAR . . .

. . . OR DROP LIKE LEAD