IPOs are more hyped then they actually should be. Some IPOs like D-mart have given spectacular returns for the investors, while some others like ICICI Prudential have proven to be duds.
So why do I have such a negative bias towards IPO's!!
My belief stems from the fact that there is an old saying in corporate circles, 'One should raise money when it is available rather than when it is needed'. This is the reason most companies come out with their IPOs during rising or bull markets when money is aplenty. Unfortunately, most investors in these IPOs come out on the losing end of the equation. Granted, some IPO deals are good for retail investors, but I’d argue the odds are stacked against you.
The stock market regulator SEBI’s rules that are designed to protect Indian IPO investors, generate reams of disclosures about the company and the offering process but unfortunately, many investors neither read nor understand these. After all, how many people have the time or inclination to read 400-500 pages of IPO offer documents? And then they say – “Please read the offer document carefully before investing.” IPOs are not level playing fields, I believe.
This game is stacked heavily against the small investor who is lured into the hype and then often loses a large part of his savings betting on listing gains.
Here are 4 reasons I believe small investors must avoid IPOs and rather search for great businesses among those already listed –
1. IPOs are Expensive- period People assume an IPO is an opportunity to “get in at lower prices”. In reality, by the time you buy shares of a company in its IPO, other parties have almost always invested earlier at lower prices – often, much lower prices. Before you even knew about the company, there probably were three or four rounds of private investment, and the per-share price of ownership usually goes up with each round. In fact, one of the big incentives for an IPO is so that previous investors – founders, venture capital firms, large individual investors – can “cash out” at least a portion of what they’ve invested.
That is why most IPOs are often expensively priced. They are not priced to offer you a piece of the business at cheap or reasonable prices, but to find “bigger fools” who can get in when the “privileged few” are getting out.
One simple logic is that if you have a bottle of water in a far away desert would you drink the water first or will you give it to unknown strangers
2. IPOs Create Vividness Bias It’s important to understand that the investment bankers and underwriters of IPO are simply salesmen. The whole IPO process is intentionally hyped up to get as much attention as possible. Since IPOs only happen once for each company, they are often presented as “once in a lifetime” opportunities for the promoters and other large shareholders to cash out. Promoters and investment bankers thus create stories that are “vivid” – by using terms like “listing gains”, “bright future”, “long-term story” – and entice you to believe them as soon as you hear them. You must avoid getting charmed by that vividness. Try to go behind the beauty of that vividness, and scrutinize the IPO to see if it is really so bright and beautiful. In other words, you need to get past the “bright and shiny” stuff that surrounds IPOs because it’s easy to fall into the trap given that so many others around you are falling for the same. Don’t buy a stock only because it’s an IPO – do it because it’s a good investment.
3. IPOs Under perform
Most people who get onto the IPO bandwagon often look at the listing or short term gains they can make in the next few weeks and months. In bull markets, this often happens. However, if you consider the long term performance of IPOs, most of them under perform their peers and the general market – simply because they started off with high valuations.
4. Probability of allotment
More the success of the IPO the lesser is the probability of you getting an allotment.
Where as in case of failure of an IPO you are definitely going to be stuck with a piece of un-trad able junk. With so many negatives and the scope of only positive is the a good listing day gain the odds are stacked against you.
Now moving away from my negative bias...
Let us understand the predictability of listing day gains for a company
The Parity conditions for Predicting listing day gains for a company isn't rocket science.
The key ingredient being the the time value of money.
Parity being the scenario where an investor in an IPO doesn't loose money
For this you need to understand the HNI Investors in the market.
HNI investors are high net worth investors who is a person with an invest-able bank balance of Rs.2,00,00,000/- In an IPO they generally apply for amounts greater than 2 lakhs .
Unlike retail investors who are not guaranteed an allotment, HNIs are allotted share on proportionate basis in an IPO. i.e if the issue is oversubscribed by 5 times in HNI category, then for every five shares you have bid, you will be allotted one share. If its under subscribed (below 100%), then you will be allotted the number of shares an investor has bid for. And the cash is unblocked in your only five days after issue. And the listing takes place 15 days post issue.
This is where the problem area lies. If an issue is oversubscribed 10 times (in Non Institutional Investor category), then an HNI must apply for Rs 1 Crore Worth of shares, to get Rs 10 lakh worth of shares. And an HNI doesn’t necessarily hoard cash in account to the tune of Rs 1Cr. Brokers will then offer them a loan which means – you only put what you want to buy, we’ll give you the “multiple” as a temporary loan. For every Rs 1 Lakh an HNI invests, he gets a loan of Rs 49 Lakh, to allow for an application of 50 lakh rupees.
So if an investor is applying for an IPO which is oversubscribed by 10 times then, Investor invests Rs 2 lakh and rest Rs 98 Lakh is given as a loan by the broker. Assuming the interest rate is at 7% and HNIs usually invest on last day of IPO. The investor will be allotted Rs 10 lakh worth of shares. Out of which he has invested Rs 2 lakh and rest Rs 8 lakh is borrowed.
So the un-allotted cash of Rs 90 lakh is redeemed after 5 days. the investor needs to pay interest of Rs 8,630 for five days at the rate of 7% per annum. (This is low – and tends to be – because of some cross financing arrangements)
The IPO listing will happen after 15 days. The investor need to pay back on the listing day (though not mandatory). Thus he will be again paying interest for Rs 8 lakh for 15 days. it amounts to Rs 2302. So Net he will be paying an interest of Rs 10,932, even before the IPO gets listed. Which is almost 1.1% of his allotment. So the IPO has to trade at least 1.1% higher on the listing day.
Case 1: If on Listing day stock trades 5% higher than issue price on the opening day. Investor sell his allotment for Rs 10,50,000 and has generated a return of Rs 50,000. Investor net profit will be 50,000 – 11,000 = 39,000 Thus his net return on Rs 2,00,000 is Rs 39,000, thus netting a profit of 19.5% on capital.
Case 2: If on listing day Stock trades 5% below the issue price on opening day Investor sells his allotment for Rs 9,50,000 and incurred a loss of Rs 50,000 Investor’s net loss will be Rs 50,000 + 11,000 = 61,000 Thus his net return on Rs 2,00,000 is Rs 61,000, thus incurring a loss of 30.5%
Now lets predict the parity price using the above calculations for Polycab
But if You are still interested in investing in IPO's these tips will help
1. Objective Research is a Scarce Commodity
Getting information on companies set to go public is tough. Unlike most publicly traded companies, private companies do not usually have swarms of analysts covering them, attempting to uncover possible cracks in their corporate armor. Remember that although most companies try to fully disclose all information in their prospectus , it is still written by them and not by an unbiased third party.
2. Pick a Company With Strong Brokers
Try to select a company that has a strong underwriter. We're not saying that the big investment banks never bring duds public, but in general, quality brokerages bring quality companies public. Exercise more caution when selecting smaller brokerages, because they may be willing to underwrite any company. For example, based on its reputation, Goldman Sachs (GS) can afford to be a lot pickier about the companies it underwrites than ABC's Investment House (a fictional underwriter).
3. Always Read the Prospectus
We've mentioned not to put all your faith in it, but you should never skip reading the prospectus. It may be a dry read, but the prospectus lays out the company's risks and opportunities, along with the proposed uses for the money raised by the IPO.
For example, if the money is going to repay loans, or buy the equity from founders or private investors, then look out! It is a bad sign if the company cannot afford to repay its loans without issuing stock. Money that is going toward research, marketing or expanding into new markets paints a better picture.
4. Be Cautious
Skepticism is a positive attribute to cultivate in the IPO market. As we mentioned earlier, there is always a lot of uncertainty surrounding IPOs, mainly because of the lack of available information. Therefore, you should always approach an IPO with caution.
If your broker recommends an IPO, you should exercise increased caution. This is a clear indication that most institutions and money managers have graciously passed on the underwriter's attempts to sell them stock. In this situation, individual investors are likely getting the bottom feed, the leftovers that the "big money" didn't want. If your broker is strongly pitching shares, there is probably a reason behind the high number of these available stocks.
The Bottom Line
Some investors who have bought stock at the IPO price have been rewarded handsomely by the companies in question. Every month successful companies go public, but it is difficult to sift through the riffraff and find the investments with the most potential. Just keep in mind that when it comes to dealing with the IPO market, a skeptical and informed investor is likely to perform much better than one who is not.
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Very insightful!