7 Ways Investors Can Cut Risk in a Hot IPO Market

Richard Satran

Initial public offerings are heating up again a year after Facebook's flop, and people investing in new stocks on their first day of trading have been beating the overall market so far in 2013.

Year to date, the average new issue is up about 19.9 percent, based on the First Trust U.S. IPO Index, versus 17.1 percent for the Standard & Poor's 500 index. In the past few weeks, two high-tech IPOs, Tableau and Marketo, soared at their debuts, and a Yahoo deal to buy Tumblr for $1 billion in cash added to the startup drama. Hype is certain to build again this year ahead of the next big thing - a widely anticipated IPO for Twitter that values it at $10 billion.

[See: 6 Things Twitter Can Do to Avoid Facebook's IPO Flop.]

The market for new issues usually lags the overall market by about six months, and the stocks' rally this year is the biggest in more than a decade. Is it time to jump in now that the IPO pool is heating up?

The conventional wisdom of most financial advisers is that you'll likely to get burned if you do. But with investment advice, a little bit goes a long way. You need to diversify opinions just like you need to diversify your portfolio.

If you do want to wade into the IPO market, here are ways to cut risk:

Avoid the hype. It's inevitable. People get jazzed by new issues. A CNBC reporter who recently called Tableau "one of the hottest IPOs I've seen in many, many years" can be forgiven some hyper-enthusiasm. The company is a fast-growing provider of big data services, and demand was strong for the shares. Even its stock-trading symbol, DATA, got investors excited. The stock soared 60 percent on its first day of trading.

It's a far cry from the most dismal debut in recent memory. "Facebook lost a third of its value last year, but it was the [purging event] that the IPO market needed," says Kathleen Smith, a principal at IPO research and investing firm Renaissance Capital. "The market re-established itself at lower valuations." Prices remained reasonable over the past year, Smith says, but adds that IPOs "will always be the Wild West" of investing, and the space is getting a little bit bubbly again. While Tableau's stock soared at the opening, it has since declined 16 percent.

Look at the growth potential. There was not much upside for Facebook. Tableau was different, a smaller company with room to grow. Sam Hamadeh, founder and CEO of PrivCo, which tracks data on private companies prior to their IPOs, says that as a rule of thumb, companies with about $200 million in revenue are the best IPO candidates. They're big enough to project revenue growth and small enough to let investors participate in the growth, he says.

Don't gamble what you cannot afford to lose. "As an investor, you want to have a game plan. It's okay if you have a bucket of play money where you can tolerate a loss but which offers higher risk and higher reward," says Michael Sheldon, chief market strategist at RDM Financial Group. "That does not mean to gamble a la Las Vegas." Sheldon has a five-point checklist of things to look for with a company going public: profit, positive cash flow, a capital structure without too much debt, a solid management team and a management team that is invested in the company.

[Read: Is There a Rocket Science Behind IPOs? ]

Invest in IPO funds for a more diversified approach. Renaissance Capital manages a fund that invests in a range of IPOs when they go public, which minimizes the risk of individual, overvalued stocks falling. Smith says her company's managed fund, Global IPO Plus Aftermarket Fund, which has a 1.5 percent expense ratio, selects stocks with the best prospects for gains as they start trading and holds them for two years, on average. It is up 22.9 percent so far this year. With a lower expense ratio of 0.6 percent, the First Trust IPOX Index ETF has returned just under 24 percent over the last 12 months. Renaissance plans to offer an ETF later this year.

The IPO market overall has become more stable because "financially weaker companies are being screened out of the IPO market," says PrivCo's Hamadeh. Instead of high-traffic, low-revenue companies like Tumblr and Instagram going public, as they once might have, they are being bought by larger, cash-rich tech companies like Yahoo or Facebook. The mix of IPOs, meanwhile, reflects a range of sectors, not just tech concerns. New issues also now pay an average dividend of over 1 percent, another departure from the past, according to Renaissance. Real estate companies and homebuilders have boosted the average, and financial companies represent the biggest sector.

See what the stock does when it starts trading. During the tech boom, the bad news was that you could not get hot IPO shares if you wanted them. That's not the problem it once was, says Smith. Today, the rise of the private market in pre-IPO shares means you could buy in, but investors might not want to jump in on the first day of trading since those markets can bid up share prices even before they go public, as happened with Facebook. Institutional investors who buy in the open market are "a demanding bunch, very picky," says Smith. They use what they have learned about the IPO company in pre-launch presentations, and they watch who is buying and selling after trading starts. "There is a lot more information after a company starts trading than there is in the very illiquid trading beforehand," says Smith.

Use your IPO fund to diversify. Do IPOs fit into an average investor's portfolio? RDM's Sheldon says, "You do not put all of your eggs in one basket. But it is possible to see it as a diversifier. It's a high-risk and high-volatility sector. That seems to be where it would fit into a portfolio." Smith adds that there is a low correlation between IPOs and the overall market, meaning IPOs offer diversification. IPOs fall more in bear markets, and rise more in bull markets.

Watch for the bubble. Everyone knows the upside. Some stocks roar out of the gate and never look back. The lure of the IPO is the chance to get in early before the investing pack discovers the fast-tracker that eventually becomes the next Cisco. If you bought 100 shares (worth $2,250) in the open market as Cisco started trading in 1990, you would have made more than $2 million in 10 years, according to the company's investor site. (Alas, if you didn't sell in 2000, it's only worth $330,000 now.) But the lure of the golden IPO inevitably leads to frothy investing. The wild successes of the Ciscos and Apples are sometimes followed by waves of overhyped eToys and Webvan offerings that go bust.

This past month was the best in nearly a decade in terms of the volume of new issues and trading gains for stocks going public. So is it time to stand aside and wait for the bubble to pop?

[See: 6 Virtual Currencies That Went Bust.]

"The IPO window has been cracked open [so far this year] - and this month may be wide open," says Hamadeh. The market has not been open to early-stage companies that do not show big revenue growth and clear profit potential. He adds: "Once you see even the small, low-quality companies start to IPO ... that's when you know that we have an IPO bubble."

Coming up on the list of companies going public are two companies that will test the appetite of investors for IPOs. Sprouts Farmers Markets is a profitable and fast-growing organic and farm-grown food chain that sells kangaroo, bison, venison and ostrich meat and is based mostly in the Southwest. Claire's Stores is a familiar retail name in costume jewelry that avoided bankruptcy when it was taken over in a private equity deal. It will go public again soon - and will test whether investors want to swallow a company with more than $2 billion in debt.