Hot Issue

What is a Hot Issue?

A hot issue is an initial public offering (IPO) with overwhelming public demand that sells more than its initial offer price on the first day of the public price immediately after it starts trading. Prior to the offering, the issuing company generates an interest in the offering through staged roadshows.

With a fixed number of shares up for grabs and dozens of investors lining up for IPO allocations, the hot issue garners much attention and excitement, further driving up demand by investors. It usually experiences price run-ups during the first day of trading.

Understanding Hot Issues

Investors are not readily willing to part with their money to fund closely held companies. However, companies that exhibit new technological breakthroughs, such as a biotechnology company with an end-stage trial or a company with a sharing economy model, can create hype and capture public investors’ attention ahead of a potential IPO. Investors believe that their access to such public offerings can bolster other profitable aspects of their business.

Before making public offerings, a company’s gestation period can be long or short, depending on whether the founders and investors choose to pursue an exit strategy or yield some control. The company may also choose not to pursue public offerings, either voluntarily or involuntarily. Such a decision may be attributed to a company’s modified business prospects or unfavorable market conditions.

The characteristics of a new company predisposing it to become a fast-growing business may not allow it to sell its shares through IPO. In addition, a private company may sometimes be acquired even before it goes public. However, a company’s shares become a hot issue when they spark interest among investors.

How a Hot Issue Works

A widely followed company that intends to acquire IPO allocation first registers using Form S-1. The company lists its current business model and competition, planned use of capital proceeds, and other important information. Underwriters-sponsored roadshows often follow the registration statement. The idea is to generate market demand and evaluate the market outlook before introducing the offerings to potential public purchasers.

During the roadshows, the intended issuer’s management team makes brief presentations and speeches. They feature live shows and multimedia materials regarding the financial outlook and the current business strategy.

Regulatory standards are strictly applicable during the roadshows, which usually include offerings that are exempt from registration. In the same vein, antifraud provisions of the security laws are also applicable to the oral statements made at roadshows.

Pricing of Shares in a Hot Issue

Once satisfied that the IPO will translate into substantial financial profits, potential investors make their orders to the lead underwriters. At such a point, only a fixed number of shares are issued to curb oversubscription. The practice is premised on the idea that high demand for shares will lead to price run-ups. Financial accounting yardsticks do not predetermine the final price of a hot issue. Rather, it is priced after the market close of the IPO date.

Underwriters enjoy unlimited discretion regarding the allocation of IPOs that do not involve broker-dealers under the National Association of Securities Dealers (NASD) laws. After determining the offering price, shares in hot issues are usually sold and transferred overnight to the accounts of institutional investors.

Retail investors are not able to access the IPOs, and they may be barred from cashing in on their holdings by restrictive lock-up agreements. The institutional investors flip and spin their allocated shares to secure an immediate profit from the hot issues’ inflated trading price in the aftermarket.

Impact of High Trading Volume

The hot issue opens for trading on a national stock exchange the next day. IPOs may sometimes open with a minimum 20% price pop and remain hot for some time. It may seem satisfying to the company’s executives for the success of the IPO opening, and eventually, justify the management’s effort to market its good prospects. However, the volatility in shares is an indicator that shares of a hot issue were sold at an artificially low price.

Speculative investors or those who could not get enough shares during the initial offering snap up shares during the price pop-ups immediately after the shares begin to trade. Such investors are after quick trading profit and do not value the shares as long-term investments. It can cause a hot issue to experience a high trading volume during the first trading day.

Also, such a scenario poses far-reaching consequences for the issuer and can dilute its stock and deprive it of capital needed to make it stay afloat or fund other projects, such as R&D or marketing campaigns.

Related Readings

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• IPO Process
• Prospectus
• Roadshow Presentation
• Use of Proceeds Statement
• See all capital markets resources
• See all equities resources