A bull market is rocket fuel for the IPO market, so the Dow Jones Industrial Average hitting all-time highs should make easy pickings for investors monitoring new offerings, right?
The IPO market has become a much different place ever since the dot-com implosion of the late 1990s. It’s no longer possible to just randomly pick a stock in a hot sector and make a tidy profit; institutional investors now have long memories and have become much more selective.
Hot Ain’t Always Hot
Consider the hot trend of cloud computing. While the technology has been around for more than a decade, it has picked up strong momentum during the past few years. The pioneer in the industry, Salesforce.com (NYSE:CRM), is a case of the fortunes that can be made — shares have improved an eye-popping 1,063% since coming public in mid-2004.
But cloud companies aren’t a lock for profits. Just take a look at Bazaarvoice (NASDAQ:BV), which came public about a year ago at $12 and now is trading at $6.78.
The company is a top player in leveraging the cloud to help companies analyze social media. But this type of solution hasn’t proven itself a must-have market. Interestingly enough, Bazaarvoice even noted this in its S-1:
“It is uncertain whether the market in which we operate will continue to develop or if our solutions will achieve and sustain a level of demand and market acceptance sufficient for us to continue to generate revenue and achieve profitability. Due to our evolving business model, the uncertain size of our market and the unpredictability of future general economic and financial market conditions, we may not be able to forecast our growth rate accurately.”
There has been plenty of truth to that last sentence — Bazzarvoice has missed earnings expectations several times, spurring many investors to give up on the stock. Sure, BV stock might eventually turn around and turn to gold, but as of right now, it’s no gem.
Look at Mission-Critical Businesses
When looking at new hot opportunities, focus on companies that address core markets. A good example is WorkDay (NYSE:WDAY), which develops cloud-based software for enterprise resource planning — that includes applications for financials, inventory and human resources, among others. That is mission-critical.
WorkDay also focuses on large enterprise customers, which has several advantages. There’s little competition — WorkDay fights mostly SAP (NYSE:SAP) and Oracle (NASDAQ:ORCL), both of which still rely primarily on traditional software systems, which has led WDAY to snag some big contracts. Also, enterprise customers tend to be “sticky,” which means that after they implement software, they tend to keep it for a long time.
The result has been a juicy recurring revenue stream — and for investors, a 120% return since its IPO in October.
As with any investment, IPOs require you to do your homework.
As seen with WorkDay, this means looking for companies that are addressing core areas flush with customers willing to throw money at solutions. Sometimes, identifying this is as easy as viewing the “Business” section of the S-1, which can give you an idea of whether the business is sustainable. If you see it’s not, then you’ll probably also see lots of volatility in revenues — and that can be a killer for IPOs.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of “How to Create the Next Facebook” and “High-Profit IPO Strategies: Finding Breakout IPOs for Investors and Traders.”Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.