IPOs have valuation and information risks

Wait for some time after the listing. You might actually get the stock cheaper once the euphoria is over

Over the past year, 39 initial public offers (IPOs) of more than ~1 billion have hit the markets (we have deliberately ignored the smaller-sized IPOs, where the companies tend to be less well known, and hence riskier). Of these, 21 have given positive returns while 18 have given negative returns ( see table). Only 14 of these 39 IPOs, or around 36 per cent, have managed to beat the returns that an investor could have earned by simply investing in a Nifty-based exchange-traded fund (average return 13 per cent over past one year). Moreover, if you had bet on one of the poorerquality issues, you risked ending up with negative returns to the tune of 2.82-44.09 per cent. With several more IPOs lined-up in July, and growing headwinds in the market, do your due diligence before investing. Valuations tend to be rich: An IPO is a means through which the promoter tries to earn returns for all the risks he has taken and the hard work he has put in. For early-stage investors in the company, too, this is a time to earn hefty returns on their bets. Investment bankers, who help the promoters with the IPO, too would like to set the maximum price possible, since their fee depends on how much money they can garner for the owners. “All the three parties have a vested interest in setting the price at the highest possible level that the market can support. Also, most IPOs come when market sentiment is upbeat and investors are willing to pay higher prices. This means that IPOs are likely to be expensively priced," says Ankur Kapur, founder, Ankur Kapur Financial Advisory Services.

An investor investing in the secondary market can take advantage of price fluctuations to invest in a stock when its valuation turns attractive. This can happen either when the mood in the entire market is depressed, or when negative news affects the stock of a particular company. If the investor’s research tells him that the setback to the company is temporary, he can use the price correction to enter that stock.

Information available is inadequate: Another risk of investing in IPOs arises from the fact that the financial data available on the company is limited. “To arrive at the correct valuation of a stock requires data of at least the past 10 years. In the red herring prospectus of IPOs, you will find data for the past three years, which is inadequate,” says S G Rajasekharan, who teaches Wealth Management at Christ University and is an avid equity investor. He adds that promoters usually launch IPOs during a buoyant phase in the business cycle-when their financials are looking good. When the inevitable downturn comes, these numbers often take a nasty plunge. Since the investor did not have an opportunity to check the company’s performance during both an upand a down-cycle, he can sometimes get an ugly surprise when he invests based just on three years’ data.

Companies that have been trading on the exchanges for a long time are less likely to throw up unpleasant surprises as more information is available about them. They have to make disclosures to the stock exchanges regularly even about small developments. Analysts who have been tracking a listed company for a while gather a fairly good idea about such qualitative aspects as the competence and character of the management. Such details are not available for new companies.

Lure of listing gains can lead to losses: Amid all the marketing hype that surrounds a company during the IPO period, many investors get attracted to bet on them for listing gains. In bullish market conditions, it is possible to profit from listing day gains. But sometimes, if market sentiment turns negative suddenly, or if a stock’s valuation is set at a very expensive level, the stock price can plunge on the very first day. Many experts, therefore, regard investing for listing gains as akin to gambling. They suggest investors should avoid such bets as the risk of losing one’s capital is high.

Given the risks described above, investors should give most IPOs a miss. Instead, if a stock that has debuted on the bourses appears fundamentally attractive, or belongs to a new sector for which there are no listed peers, investors should calculate the valuation at which they will have a high probability of making a profit in the stock. They should then wait patiently for the stock price to descend to that level in the secondary market. Jimeet Modi, chief executive officer, Samco Securities, says that investors should wait for 200 days before investing in a newly-listed company. This, according to him, is the time it takes for the IPO-related hype around a company to dissipate and for the price to settle down to a more realistic level.

Prithvi Haldea, founder and chairman of Prime Database, suggests that retail investors betting for listing gains should rely on the response of Qualified Institutional Buyers (QIBs) to the IPO. "If the QIB section is oversubscribed, that usually leads to a price spurt on listing date," he says. Some comfort can also be gained from the presence of private-equity or venture capital investors in a company going for an IPO. According to Haldea, this indicates that due diligence has already been done on the company by a sophisticated institutional investor, and so it is likely to have better standards of corporate governance. He adds that it is a good sign if these investors are exiting only partly from the company during the IPO, as it indicates that they see the stock price rising further in the future.