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Stay Clear of IPOs

Conventional wisdom says IPOs are suitable for small investors. Nothing could be further from the truth…

Like the ‘i’ of Apple Computers the ‘e’ is a common prefix that indicates some sort of internet-based transformation taking place in the object so prefixed. Last month, when markets regulator Sebi unveiled a slew of reforms aimed at mutual funds, IPOs and financial advisors, IPOs too have had an ‘e’ applied to them. Sebi’s statement said that it would make available the nationwide broker network of the stock exchanges to make IPOs available at more than a 1,000 locations.

Investors at these locations would be able to approach a broker and apply for this e-IPO through these brokers using the exchange’s network. This would bypass the current system of physical forms and make the whole process simpler and faster. The main goal of this exercise is the geographical expansion of the locations where IPOs are available, and to facilitate the small or medium-sized individual (‘retail’) investor to invest in IPOs in greater numbers. Another change that Sebi has announced specifically changes allotment rules for the retail investor. Here’s what Sebi’s statement said, “The share allotment system will be modified to ensure that every retail applicant, irrespective of his application size, gets allotted a minimum bid lot, subject to availability of shares in aggregate. The system will satisfy more number of smaller applicants in the oversubscribed issues.”

While the detailed arithmetic of this measure has not yet been announced, the goal is very clear. Up till now, in popular and heavily oversubscribed IPOs, big investors are able to crowd out smaller ones. Since heavy over-subscription is expected, investors with deep pockets leverage their funds and apply for many times the amount that they actually wish to acquire. Small investors are unable to do this and lose out in heavily skewed allotment ratios. While it remains to be seen how effective this measure is if a popular IPO is launched in the middle of a booming market. Savvy Wealth Insight readers should actually step back and re-examine the rationale behind investing in IPOs. In India, investors, financial advisors, and the government have always considered IPOs to be especially suitable for retail investors. I think this belief should be critically re-examined. Once upon a time, in the pre-reform days, a successful IPO application would automatically mean windfall gains on listing.

Filling up IPO forms was considered to be a simple activity that was well-suited to retail investors who didn’t have the stomach for the hurly-burly of equity trading. Those days are long gone. IPO gains are far from automatic nowadays when issues are priced very close to (or in excess of) their intrinsic value. IPO companies are less well-known and well-researched and retail investors have less of a chance of avoiding the dud issues. Listing gains are less certain.

All this means that regardless of the encouraging moves by Sebi, individual investors should avoid IPOs. On balance, IPOs will either be over-priced, or over-supplied or heavily over-subscribed. One or more of these will eventually ensure that your gains will be few and far between, or that you’ll get a small allotment and the actual amount gained will be trivial.

This is actually quite unfortunate because in a fundamental way the primary reason for the stock market’s existence is to channelise savings into fresh capital for businesses. However, money is fungible and given the actual situation its better if retail investors invest in well-researched existing issues and institutions and large investors take the risk of IPOs.

Hopefully, in the long run, IPOs in India will evolve to fully electronic, live, web-based auctions where price discovery is transparent and no class of investor has an advantage over any other. Perhaps Sebi’s new e-IPO will prove to be a first step in that direction.