What to Ponder as the IPO Market Heats Up in 2011...

Rather than focus on the turmoil in Egypt or rehash a number of economic statistics that imply the economic recovery remains a steady but slow one characterized by modest job growth near term, let's instead look at another facet of the market. No, I'm not talking about mergers and acquisitions, more commonly referred to as the M&A market, but rather the capital markets and the recent resurgence in the initial public offering or IPO market.

IPOs started showing some glimmering signs of life with more than 150 U.S. such transactions in 2010, as per Renaissance Capital, up from 63 in 2009 and 31 in 2008. Now to be fair, 2010 is not the record leader in terms of the number of IPOs, but it was the first year since 2007 when the number of IPOs was back in the triple-digit range.

That positive 2010 momentum continued into January as $59.5 billion was raised from equity sales, including Nielsen Holdings' (NLSN) $1.9 billion IPO, the largest IPO this year. Two other companies — NeoPhotonics Corp. (NPTN), which makes photonic integrated circuit-based modules and subsystems for high-speed telecommunications networks, and Epocrates Inc. (EPOC), a company that specializes in handheld applications for doctors — both went public this past week and both are above their respective issue prices.

That $59.5 billion was the most in any January since Dealogic began tracking the data in 1995, and already this year, the global IPO backlog stands at $46.3 billion. Included in that global backlog figure is an estimated $9.9 billion associated with Glencore International's IPO. Glencore is closely held Swiss commodities firm that plans to list its shares on stock exchanges in Hong Kong and London.

That company aside, other significant U.S. IPOs are in the pipeline for this year, including Kinder Morgan (the largest independent operator of refined-petroleum-product pipelines in North America), hospital operator HCA, and Toys 'R' Us.

Several factors have contributed to the IPO resurgence and it appears the window of opportunity remains open near-term. As the economy continues to solidify and the investors, both professional and self-directed, have greater comfort in the market, companies are able to tap in this IPO appetite after a few years of what has been essentially a freeze-out. It should come as no surprise then that private equity and venture capital shops are set to unleash a wave of public offerings of companies they control. Those types of investors need to post returns and favorable performance just like mutual fund and hedge fund managers — it's part and parcel of keeping their investor base happy while scouring for fresh assets to manage. Personally, I like the IPO market as it helps refresh the number of companies out there that we can potentially invest in — new blood as it were.

In my opinion, the danger in the IPO market exists when it becomes "overheated" or "frothy." That's Wall Street talk for the IPO market being in a near frenzy with a number of transactions being priced in a week's time. The reality is that an overheated IPO market can lead to certain companies going public that perhaps should either not be or that have issuance prices far higher than they should be. Thus far, it does not appear we are approaching that state.

For the individual investor, there are a few ways to invest in newly public companies. One is to buy the shares directly, however there are risks associated with that strategy. These include the absence of long track record, which would allow you to gauge performance of a company and its management team over time; little if any research reports on the company as the underwriters have to wait a period of time before issuing initiation of coverage reports on those companies; and lock-up period expirations.

A lock-up period is the time during which early buyers — majority shareholders and company insiders primarily — are not allowed to sell their shares. When it expires, they are able to do so, and if the share price has performed well, some if not all of those folks tend to take some of their chips off the table. One example is Tesla Motors, Inc. (TSLA) — the lock-up period expired in late December and the shares have been below November- December 2010 levels ever since. Most IPO lock-up periods fall between 90 and 180 days after the shares are publicly traded.

A second way to participate in the IPO market would be to invest in a mutual fund or exchange traded fund (ETF) that specializes in IPOs. Examples include the First Trust US IPO Index Fund (FPX) and the IPO Plus Aftermarket Fund (IPOSX). As with investing in individual securities, there are risks associated with investing in any mutual fund or ETF. Be sure to understand the strategy of the fund, including how it has handled periods of time when the IPO market has cooled, and make sure its risk tolerances are in sync with your own.