How Security Markets Work 

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How Security Markets Work

New issues of common stock and preferred stock are sold in the primary markets. In other words, the primary market is the market in which new securities are sold to the market. The secondary markets are where existing securities are traded among investors through an intermediary.


New issues of stocks that are sold for the first time are initial public offerings (IPOs). If a company that has already issued stock on the market wants to issue more stock, it is referred to as a new issue. eBay, Yahoo!, and Google were extremely successful IPOs on the market in the late 1990s and early 2000s.

Most IPOs and new issues of stocks are marketed and sold through underwriters (brokerage firms). Most of the underwriting of common stocks takes one of three forms: negotiated arrangement, competitive bid, or best-efforts arrangement. These different arrangements are due to different terms and conditions agreed to between the issuing company and the brokerage firm and do not have a direct effect on the individual purchaser of the securities. What you should know about buying new issues or IPOs is that you do not pay a commission to buy the securities from underwriters. The issuing company pays these fees.

Companies issuing securities in the primary market are required to provide investors with a legal document, called a prospectus, so that they can make prudent investment decisions. The prospectus is a formal document related to the offering of new securities that provides information to investors interested in purchasing the securities.

Returns from IPOs

IPOs generally give investors a wild ride in terms of returns. In September 1998, eBay, an Internet company, was brought to market at an issue price of $18 per share, and 31⁄2 months later the stock was trading at $246. This 1,267 percent return took place over 3 1⁄2 months. Not all IPOs are like eBay, though. Generally, many IPOs increase in price on the first day of trading owing to the heavy demand for the stocks, but over long periods of time they tend to underperform secondary issues. A study done by Christopher B. Barry and Robert H. Jennings (1993) showed that the greatest return on an IPO is earned, on average, on the first day the stock comes to the market. Professor Jay Ritter (1991) concluded that an IPO’s long-term performance is much poorer than that of companies trading on the secondary markets (existing shares traded on the markets). Ritter updated his research to include returns from IPOs during the five years after issuance from 1970 to 2002, indicating that IPOs underperformed other firms of the same market capitalization by an average of 4.2 percent, excluding the first-day return. In addition, the Wall Street practice of imposing penalties on brokers who sell their clients’ shares immediately after issue is disadvantageous for small investors (Zweig, Spiro, and Schroeder, 1994, pp. 84–90). Table 7–1 offers an explanation of how IPO shares are allocated and who gets them.

One reason for a decline in price of IPO shares after a period of time might be that company insiders sell their shares. Executives, managers, and employees of a company can purchase their own stock or are granted options on the stock. Insiders usually must hold the stock for a period of time, known as a lock-up period, which typically ranges from three months to a year. When the lock-up period expires, company insiders can sell their shares, which can cause the share price to fall.

Table 7-1
How IPO Shares Are Allotted and Who Gets Them

Investors of all types have tried diligently to obtain IPO shares because of the spectacular returns earned by many IPOs over short periods. Therefore, if individual investors have a hard time getting these shares at issue, who does get them?
The issuing company distributes a portion of the IPO to its friends and family members. The underwriter also allocates its shares to privileged investors, such as institutional investors and mutual funds. Smaller allocations go to the brokerage firms’ wealthy investors. The average small investor is positioned low on the institutional totem pole.
No rules or regulations govern the allocation process. The National Association of Securities Dealers (NASD) bars investment banks from selling these IPO shares to senior officers who are in a position to direct future business back to their investment banks (underwriters).

The IPO market has some disadvantages that you should be aware of before investing:
* Institutional investors get very large allocations of shares, leaving a small percentage available for individual investors.
* Institutional investors are privy to better information than individual investors.
* Individuals rely on information primarily from a prospectus; institutional investors can attend road shows and meet company executives. Cheat sheets, provided by brokerage firms to their preferred institutional clients, contain management forecasts and income projections that are not part of a prospectus. Companies are reluctant to include cheat sheets in their public documents; if a company misses its published projections, it might be vulnerable to lawsuits.
* Individual investors are penalized for selling their shares immediately after issue, although institutional investors are allowed to quickly “flip” their shares.

If you want to participate directly in the IPO market, you should be aware of these disadvantages. You might consider instead investing in mutual funds that concentrate on IPOs.

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