Today we have the special honor of learning about IPOs from Zachary D. Scheidt who runs a fund that focuses on IPOs and their effect on the markets. His analysis is sought after daily with new IPOs and historic IPOs. Please take the time to read his article prepared just for Trader's Blog readers. Have a great Sunday.

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When I tell people that I run a fund that primarily trades IPOs, I often get a blank stare. It’s a bit of a shame that some of the more profitable opportunities on the street are often unrecognized and passed over by many individual investors.

Ironically, one of the reasons many people are not aware of a newly issued stock is because of restrictions placed on research firms who may know the very most about the new company. The regulations are actually in place with the intent of protecting investors from conflicts of interest, but even the best set of rules sometimes have unintended consequences. To understand how the process works, let’s start at the beginning and explain the complete IPO process.

Imagine you started a new company based on a new invention you created. You put your life savings into getting the patent, creating a prototype, and you have begun to sell this invention to a few retail shops around your hometown. The company is successful, but in order to truly realize its full potential, you need to build a factory for mass production, hire a bigger sales-force to market the product nationally, and you would like a way to get your capital back when you are ready to retire. Well you are probably a prime candidate to sell a portion of your company in an IPO.

Now an IPO is simply an Initial Public Offering – or the first time a stock has been offered to investors and traded on a public market. Typically, the business owner will offer only a portion of the company (for example lets use 30%) and keep the rest of the company as his own position. So we might assume that there are 300,000 shares being offered to the public and an additional 700,000 held by the business owner.

Typically, a business owner will go to an underwriter (you would recognize some of these firms such as Morgan Stanley, Goldman Sachs, Merrill Lynch or Lehman Brothers. An analyst at one of the underwriting firms would take a look at your business model, asses what he thinks it might be worth, draw up the legal papers (called a prospectus) and then begin to search for buyers who are interested in owning a piece of your company.

The underwriter may face challenges in finding buyers for your firm. After all, there is no history of this company trading, and investors would be taking a bit more risk on this relatively unproven company. Usually the underwriter tries to set a relatively attractive price on the issue so that he can find enough willing buyers and so that those buyers actually are likely to realize a gain once the stock starts trading. So lets assume that the underwriter believes the company is worth a bit more than $10,000,000 and we have already assumed there will be 300,000 shares offered and another 700,000 shares held by the entrepreneur.

After speaking with many clients about the offering, and possibly introducing management to some of these key clients, the issue is placed on the calendar and expected to begin trading on a certain date. Now its time for investors to put their money where their mouth is. The underwriter takes Indications of Interest (IOIs) from clients which means that the client actually tells the underwriter how many shares he would like to buy. If the deal has a lot of demand, it is considered to be “oversubscribed” and most clients will only get a portion of the stock they indicated for. However, if there is a smaller amount of demand, clients will likely get “allocated” the entire amount that they asked for.

Sometimes the price has to be adjusted as well to fit with the demand (if there is not enough demand, they may price the IPO stock below expectations in order to find enough buyers for the 300,000 shares being offered. If an IPO prices below the expected range, that is usually a pretty good indication that demand is light, and investors should be cautious as the potential for further weakness is much higher. Conversely, if underwriters sense strong demand for an IPO, they may actually price the deal above the range published in the preliminary documents. This is definitely a positive for the business owner who is receiving more for the 30% of the company he is selling. Ironically, investors who pay higher prices for the IPO have a better chance of making strong profits because the higher price points to extreme demand in the marketplace.

Once all the shares have been allocated and the wrinkles are ironed out, the stock starts trading in the open market and investors can buy and sell shares. At this point there is nothing different between buying this stock or any other public company. Often, there is great opportunity for trading gains as the company is less well known than existing stocks that have been trading for a period of years. This means that someone who is willing to roll up his sleeves and research the true value of the company may be able to uncover issues that are not yet fully discounted in the stock price.

The reason the market may not have all the fundamental facts priced in is because analysts associated with the underwriting firm are technically barred from issuing an opinion for a period of time after the deal is brought to the public. The rule is in place because there would be a conflict of interest between the underwriting firm and the business owner as the stock is being issued. It would be tempting for an underwriting firm to agree to publish an overly optimistic report in order to drive demand for the deal.

To counter this conflict, the SEC has required a “quiet period” during which an underwriting firm (who ironically knows more about the newly issued company than anyone) may not publish a recommendation. In the mean time, it is possible for individual investors to do their own homework and possibly buy into a company before the official analyst issues a report later. If the analyst is positive on the company it will likely drive the share price higher as the underwriting firm’s clients begin to buy the stock in earnest.

So for individual investors, the challenge is where to find IPO information in order to make an educated decision on whether to invest or not. I have found that a small website called morningnotes.com does a very good job of giving an overview of upcoming IPOs and how they will potentially trade in the open market. Secondly, Investors Business Daily keeps a running table of soon to be priced companies as well as recent IPOs. Finally, the SEC has all the formal documents that are issued by companies in the IPO process. While some of these reports will put you to sleep, there is good information as to the nature of each business, the balance sheet and income statement, and interestingly, who owns the bulk of the remaining shares.

Investing in IPOs should not be a mysterious process. There is ample opportunity to uncover hidden growth companies, and the information is available and is often free of charge. It just takes a bit of homework to determine the best companies.

Zachary Scheidt is the Managing General Partner of Stearman Capital, LP. The fund focuses on recently issued securities and companies issuing IPOs. Mr. Scheidt received his MBA from Georgia State University and has earned the Chartered Financial Analyst (CFA) designation. He authors a blog at www.zachstocks.com highlighting stock ideas for individual investors to pursue.