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August 31, 1998

How IPOs Test Traders

By Stephen Lacey

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  • How IPOs Test Traders

The initial-public-offering market appears to be a victim of its own success. An excess supply of stocks, combined with the market's recent sluggish performance, has hurt potentially lucrative IPOs, making them tougher sells.

The pain caused by dramatic market dips and a slowdown in the IPO market is not confined to individual investors. Traders on both the sellside and the buyside know of the agony.

"It makes our life more demanding," admitted Raymond Murray, director of trading at Minneapolis-based Investment Advisors.

For one thing, uncertain expectations can cause portfolio managers to suddenly drop out of a pending IPO, and leave traders feeling a little flabbergasted. (Conversely, less competition over IPOs can enhance some institutional firm's allocation prospects.)

For another thing, some traders said that money flowing into mutual funds is not keeping pace with the flood of new issues, thus hurting the trading performance of seasoned stocks competiting for a proportionately smaller pool of capital.

Moreover, the tremendous supply of new offerings hitting the market over the past three years has partly contributed to the relative underperformance of small-cap stocks, market sources noted.

"There's enough pain for investors, and they're not really interested in adding new stocks to their portfolios," said Tom Dudenhoefer, head of Nasdaq trading at Raymond James & Associates in St. Petersburg. "The general response we're hearing is, I don't need to add a new name in that industry when I already have four other companies in the same sector that are underperforming.'"

"There's been a real liquidity crunch in the stock market in general," added Bruce Lupatkin, director of research at Hambrecht & Quist in San Francisco. "The supply of large-cap names doesn't grow nearly as fast as the supply of small-cap names."

Institutions

Institutional clients, comprising the bulk of an offering's book and the majority of first-day trading activity, have largely vacated the IPO market to concentrate on their existing holdings, according to trading officials.

"IPOs are an interesting anomally to the overall market," Murray said. "With an IPO, you have the chance to safely land on the beach when you want. Lately, underwriters have been saying to themselves, I'd like to land on the beach when their is a little less gunfire.'"

In the midst of a plummeting Dow Jones Industrial Average, just 16 issuers were able to bring deals to market in August. In contrast, underwriters were able to place a total of 47 IPOs in July.

With the pace of IPO issuance slowing and many underwriters forced to severely discount deals due to market conditions, first-day trading volumes have soared on many recent deals.

"IPOs generally price at about a 20-percent discount to publicly-traded comparables," noted the head of one over-the-counter trading desk, who requested anonymity. "Ideally, an underwriter would like to see very little volume in the initial day of trading."

With the market's recent volatility, however, such discounting has become accelerated, leading to higher-than-normal first-day trading activity, traders said.

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