It's vital you know what you're signing up for.
When a private company wants to raise money by selling shares, one way it can do so is through an initial public offering (IPO) whereby it offers them to the public shortly before they are listed upon a stock exchange.
One of the highest profile IPOs of recent times is that of Facebook, which is currently looking to raise over $10 billion at a price that is expected to value the company at anything up to $96 billion.
IPOs are a textbook example of what economists call "information asymmetry", a situation where one party to a transaction knows far more about it than the other side does. In the case of an IPO, the existing shareholders are better informed about the business than the potential buyers so they have a distinct advantage. Anyone who is thinking of buying shares might therefore wish to consider why they are being sold.
They know more than you do
Asymmetric markets put buyers at a big disadvantage due to their relative lack of information. To prevent major abuses, such as selling substandard goods without first informing the buyer, we have laws like the Sale of Goods Act 1979. This requires that all goods sold must be "of merchandisable quality" and if not, then the buyer can void the contract without penalty and is also entitled to receive a full refund.
When it comes to an IPO, the company must issue a prospectus that describes its business. Many prospective investors won't even bother to look at it, but they should as it's the best way for them to reduce their disadvantage.
In a bull market, buying shares in an IPO can be a good way to make money, as those of us who grew up with the privatisation issues of the 1980s know only too well. After all, a rising tide lifts all boats, so many bull market IPOs start trading at a premium to their issue price. This encourages people to 'stag' the issue by applying for shares, which they sell as soon as possible, turning a quick profit in the process.
But in less buoyant markets, such as those we've been experiencing for the last few years, it can be much harder to profit from an IPO. A good example of this is what has happened to shares in the commodity trader and mining company Glencore International (LSE: GLEN) since its IPO, which was almost a year ago.
As I write this, Glencore's shares are trading at 393p, following the publication of its management statement and first-quarter production report, so when compared to its IPO price of 530p, this represents a fall of almost 26%.
At the time of Glencore's IPO, many people said that its shares were overpriced. While the last 12 months haven't been good for the mining sector, as shareholders in the world's biggest miner BHP Billiton (LSE: BLT) know since their shares have fallen by some 22%, this isn't what buyers in Glencore's IPO thought they were signing up for.
One sector that is notorious for having IPOs that soon turn sour is information technology. This is because the fast-moving nature of the industry means that it's quite possible that a competitor with a better product will take away most of a company's business within a very short period of time, which is just what Facebook did to MySpace.
Back in the heady days of the dotcom boom, we saw many companies quickly fail despite having an auspicious IPO. A good example was TheGlobe.com, one of the earliest social networking websites, whose shares rose by over 600% on their first day of trading in 1998. Just over two years later, you could buy its shares for less than 5% of their IPO price.
Caveat Venditor (seller beware)
In a few markets information asymmetry works the other way, because the buyer knows more than the seller, such as when an amateur is selling antiques to a professional dealer.
One of the largest of these markets is motor insurance. That's because the person who is applying for insurance knows far more about their own driving habits than the insurance company ever will.
Consequently, insurers try to elicit information about people who apply for policies by using questionnaires. Recently, they've started to encourage drivers to have a "black box" installed in their car in order to more closely monitor their driving habits.
But since information asymmetry favours the person taking out the insurance, the law is also very strict in allowing insurers to reduce -- or even remove -- coverage if the person covered left out material information when they applied for the insurance in the first place.
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> Tony owns shares in BHP Billiton.