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No Case for IPOs

Most people think of IPOs as an easy & fruitful investment, but that is not always the case

Value Research recently did an extensive study of IPOs to try and ascertain what sort of returns retail investors had historically received. Once realistic allotment ratios are factored in, the study suggests the risk-return equation for a dedicated IPO investor hasn't been very good.

The “strike rate” is not so high because hot issues tend to be oversubscribed and that leads to “reverse leverage”. The investor must commit more cash than the actual cost of allotment and that reduces the percentage return. In addition, there is an upper limit on IPO subscription. Even if you do find an excellent IPO, the absolute returns are capped.

The risk factors rise significantly simply because it is an IPO. True, there are due diligence norms for tapping primary markets. Assume for argument's sake that the financial data is accurate, the management is honest and competent, and that all relevant risk factors have been explicitly mentioned.

There is still an added element of risk because companies usually go for IPOs only when they are trying to grow more quickly than they can via internal resources. Data about listed concerns is usually more reliable and more easily available than data for a company that is seeking listing. It is very rarely that you get a TCS or an NTPC style of IPO — two instances of market leaders with decades of experience going public.

So an IPO is almost always a bigger gamble than buying an equivalent listed business. Despite this, an entire class of retail investors, or perhaps one should call them traders, is completely focused on the primary market. They don't ever trade the secondary market except to sell IPO allotments. Some buy and hold for the long-term; most try and book profits within a few days of the listing.

However, although these retail IPO players ignore the secondary markets, their overall returns are actually hugely influenced by secondary market sentiments. The IPO investor's game-plan works best during a bear market or in the early stages of a bull market. It tends to go hay-wire during a mature bull-market.

Late into a bull-market, IPOs are most likely to be optimistically-priced. Over-subscription is almost guaranteed and allotments will occur at the top end of the band. Everybody will be scrambling to book profits hoping for listing at substantial premium to the issue price. All this creates bubble conditions and if you're on the wrong side of a bubble, the losses can be huge. During bear markets, IPOs are fewer and further between. The pricing tends to be more conservative and the allotment ratios are usually better. Premiums upon listing are somewhat less likely. If you buy and hold an IPO for the long-term during a bear market, the risk:reward ratio is somewhat better than late in a bull-market.

Subscribing to an IPO therefore involves first making a valuation of the business on data that may not be very accurate and then it involves making an implicit call on market timing. This is why value investors (Graham, Dodds, Buffett) tend to avoid IPOs and Graham in fact, explicitly warned his disciples against IPO investing. However, one can make a very, very selective case for checking out IPOs.

What about NFOs? Quite a few of the same retail players who subscribe to IPOs also subscribe to NFOs. But the odds for an NFO are actually worse. An NFO will always list at a discount and the question of booking early profits doesn’t usually arise due to exit loads and the inferior tax-efficiency of early exits. Just say “no” to NFOs unless the scheme meets three very stringent criteria.

1) The AMC has a great team of fund managers with excellent track records
2) The scheme has a strong USP.
3) The NFO is launched in a bear market. For our purposes, we can define a bear market as one where the benchmark index has seen negative returns over the period of at least 3-6 months, and preferably longer.

In the very rare case where all three of these criteria are met, the NFO may be worth investing in. Even then, it's a matter of betting almost purely on the AMC and fund-managers’ brands.

The writer is an independent financial analyst