"I have finally opened a demat account. I got it done in just 3 days" - one of my friends happily announced to me recently. Why now? I asked, curious because she had never displayed much interest in equities whenever I had urged her to start a systematic investment plan with an equity fund in the past.
"I wanted to apply for the Shemaroo Entertainment IPO because it is bound to give me a big listing gain. Look at Snowman Logistics and Sharda Cropchem", she said, much excited. By now, we all know that Shemaroo's listing hasn't been quite as spectacular as that of the two IPOs that preceded it.
But this episode is just a reminder of how topsy-turvy the Indian retail investor's strategies are, when it comes to equity investing. Investors who shun equity mutual funds even through the SIP route, because they think stocks are too risky, are all too willing to shed those inhibitions the moment IPOs begin to appear on the horizon.
IPOs, to my mind, are the riskiest class of equity investments that a retail investor can make. For one, you are betting on a company which is embarking on a brand new business or project, with very limited financial information. Read through the 'risk factors' section in any IPO document and you will know exactly how many things can go wrong with the project. Assessing any IPO in its entirety actually requires the investor to be able to assess the intrinsic value of a stock based on the future cash flows of the new project. Only this can help evaluate if the IPO price leaves enough money on the table for the investor. Forget retail investors, even institutional investors often burn their fingers on this exercise.
Two, when you invest in an IPO, you are automatically magnifying the risk of badly timing on your investment. IPO booms always happen only in raging bull markets. Just think back to 1994, 1999 and 2007 and you will see the pattern. After all, IPOs are all about promoters wishing to offload their stake in a company to public shareholders; why would they do it when market prices or valuations are cheap? It is due to these two factors that nearly half the IPOs launched over the last seven years are yet to break even for their original investors.
Three, because of the retail quota and the rush to bag allotments, retail investors usually end up betting too much money, far more than their risk appetite warrants, in each IPO. Investors who tend to think a dozen times before flagging off a ₹2000 monthly SIP, are quite willing to bet ₹1 lakh on a company they know very little about, just because there's a thin chance of a windfall gain on listing.
But despite the risks that are writ large on IPOs and the poor investor experience with them in the past, it is IPOs which seem to draw first-time equity investors into the markets time and gain. Data from the National Securities Depository Limited show that as many as 2.7 lakh new demat accounts have been added in the July-September 2014 quarter. That is nearly three-fourths the 3.6 lakh accounts that were added over the whole of last year!
If you recall, the last time the Indian market saw a record number of first-timers opening a demat account was in January 2008, when Reliance Power made its ill-fated IPO. With those investors still sitting on losses on their original investment, is it any surprise that most retail investors think equities are a losing proposition?
But why blame investors? Regulators and policymakers also go all out to encourage the false notion that IPOs make for a good investment for first-times. Every time there is talk of promoting the equity cult in India, the one suggestion that keeps cropping up is to increase the retail reservation in IPOs. The retail quota in IPOs, currently at 35 per cent, is already quite significant. What is more, investments of upto ₹2 lakh in a single IPO are deemed 'retail' for some strange reason. If one is a prudent investor who invests not more than 5 per cent of his portfolio in a single stock, one must have an equity portfolio worth at least ₹40 lakh to make such an investment. The Government too goes that extra mile to fuel the retail appetite for IPOs. Most public sector divestment offers today come with a 'retail discount' of 5 per cent or so to nudge investors to subscribe to them.
Encouraging retail investors to make their equity debut through the IPO or public offer route actually does quite a bit of damage to the 'equity cult' in the long term. For a first-time investor to keep coming back to equities, it is essential that his return experience with his maiden investment is good. Given that the probability of making a loss on an IPO is far higher than that with a secondary market investment, it simply doesn't make sense to promote the first-timers interest in IPOs.
By reducing the timing risk, betting mainly on the secondary market, using professional skills and diversifying the portfolio across many stocks, SIPs in diversified equity funds are actually the best debut product for first-time investors testing the waters on equity investing.
But how do we convince retail investors (including my friend) and the policymakers of this and cure them of the fatal attraction to IPOs?
This article was originally published on October 07, 2014.
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