If you have ever been around experienced investors in the evening, especially after a few drinks have rid them of their inhibitions and modesty, you would no doubt have heard them speak of the killings they have made investing in the initial public offerings (IPOs) of companies such as Infosys Technologies or Bharti Tele-Ventures. What they will not tell you is all the money they have lost investing in dud offerings. This is what makes earning money by investing in IPOs difficult: for every winner, hundreds of poor-quality and overpriced offerings are offloaded on investors. Those keen on investing in IPOs must, therefore, learn to evaluate them objectively. They must also possess the discipline to be able to say no to scores of poor-quality offerings.
Pitfalls of IPO market
The problem with the IPO market is that the few big winners cannot compensate for the majority of losers. An example from the US market illustrates this point well. In order to assess whether IPOs are good long-term investments, Professor Jeremy Siegel of the Wharton School (author of “Stocks for the long run”) studied all the IPOs issued between 1968 and 2001 for their buy-and-hold returns till December 31, 2003. Of the 8,606 IPOs examined, Siegel found that 6,796 IPOs or 79 per cent underperformed the returns from a representative small-stock index (the Russell 2,000 small-cap index).
Siegel also found that if a portfolio was created by allocating an equal dollar amount to all the IPO stocks over this period, such a portfolio would underperform the Russell 2000 index in 29 of 33 years.
What this study by Professor Siegel clearly shows is that the majority of the IPOs that come to the market deserve to be ignored.
Why IPOs make poor investments
One reason why most IPOs don’t make money for investors is the information asymmetry that prevails in this market. Since stocks in the secondary market have been in the public domain for long, over time both their strengths and weaknesses become apparent to the discerning investor. Not so in the case of IPOs.
One, regulations require companies coming out with IPOs to reveal only the past five years’ performance. Usually, the company’s management launches an IPO at a time when its performance has been most favourable. What is not apparent to the potential investor is how well the company’s performance will hold up during a downturn in the business cycle.
Two, only the company’s management is aware of many of the weaknesses within the company. Initially these are not apparent to the investing community.
Three, most IPOs are launched when the stock market is in a bullish phase. Prices of equities are on their way up. Since by then investors have made money on their earlier equity investments, their appetite for equities is high. Many of them drop their customary caution. In an atmosphere where anything they buy goes up, they do not evaluate IPOs rigorously and invest even in poor-quality and overpriced issues.
Remember also that a lot of sales effort goes into selling IPOs (because investment banks earn high commissions from their successful placement). They are also accompanied by high-voltage advertising. Instead of getting duped by the high decibel level and excitement, investors must put in twice as much effort into evaluating an IPO as they would into evaluating a secondary market stock.
Do the due diligence
As with a secondary market offering, evaluate IPOs for their long-term prospects. The central question to ask is whether the IPO will offer an adequate return if you hold it for five years.
Investors must read the admittedly voluminous red herring prospectus (at least important sections such as objective of the issue, business summary, and risk factors). Brokerage houses also bring out reports evaluating these IPOs (many are available on the Internet). Read them for the information they offer, but the final decision regarding whether to invest should be entirely yours.
Qualitative evaluation. Reading the prospectus and analysts’ reports will give you an insight into the company’s growth prospects. Try to find out if the debutante’s growth prospects are better than those of already-listed peers from the same industry. Also enquire whether the company has a customer base that is diversified and growing, or whether it depends on only a few customers.
Try to learn about how the company is placed vis-à-vis its competition. Is it in an industry that is highly fragmented? Or will it have to compete against larger and well-entrenched rivals? Does the company have competitive advantages that will enable it to gain market share at its rivals’ expense?
Investigate into the promoters’ antecedent and track record. Do they have a sound reputation? Do they, by any chance, have another listed company that has a sound reputation and is performing well?
Finally, assess the prospects of the sector to which the company belongs.
Quantitative evaluation. On the quantitative side, look at the company’s past revenue and profitability growth: has it been robust and steady?
Examine the profitability ratios of the company and compare them with those of already-listed peers. Only if the numbers are better does it make sense to invest in the IPO.
Ensure that the company is not burdened with a high level of debt.
Valuation. Once the IPO’s price band is announced, find out what its PE ratio will be at the lower and upper ends of the price band. How does its valuation compare against those of listed peers? If the IPO is priced at a discount to its peers, that is fine. But if it is priced at a premium, you must find out if there is something in its fundamentals to justify such a premium. If not, reject it for being overpriced.
Avoid investing for listing gains. In India investors like to invest in IPOs for listing gains (the gain in price that hot IPOs witness on the day of listing, which gives investors a quick return on their investment). There is a widely prevalent belief that shares of companies are offered at a discount in an IPO. This may have been true in earlier decades when there was a Controller of Capital Issues who fixed the prices of IPOs, it is no longer true today. In fact, promoters and investment bankers try to fix the price at the maximum possible level that the market will accept. Whether you get listing gains or not depends on a wide variety of factors: the quality of the issue, its valuation (whether the promoters have left something on the table for investors), and on the level of bullishness prevailing in the market. In pessimistic markets sometimes even good issues fail to give listing gains, while in optimistic conditions even poor-quality ones at times do so. Therefore, predicting whether an IPO will give listing gains has become difficult. Hence, investing for listing gains is a speculative activity that conservative investors should avoid. Finally, remember that all things being equal, it is better to invest in an already-listed company rather than in an IPO. More information is available on a secondary market stock and the chances of being unpleasantly surprised are smaller.