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The Rate Race Begins

My hunch is that if done properly, IPO ratings could develop not into a good preference indicator, but a useful avoidance indicator

Now that SEBI has made it compulsory for companies to get a rating for their public issues, rating agencies like CRISIL, CARE, Fitch and ICRA are soon going to find themselves being blamed for investors' losses. From now on, anyone who loses money on an IPO will try to pass the buck to the raters, whose fault it is. Not just blame for losses, if your neighbour makes more money on a company rated ‘2’ than you do on a company rated '4', then too, you'll know whom to blame. Which is a pity, because used properly, the IPO rating can be a useful tool for investors.

Despite the fact that disclosure norms have improved, the sheer volume and complexity of IPO disclosures means that it needs serious time and application to learn to understand them. This is something that few investors can do. The idea behind the ratings appears to be that IPO prospectuses are too complex for lay investors to read and a rating given by a rating agency can be a guide. SEBI states that this rating is 'a service aimed at facilitating the assessment of equity issues offered to public. The grade assigned to any individual issue represents a relative assessment of the 'fundamentals' of that issue in relation to the universe of other listed equity securities in India.'

SEBI has pointed out (and no doubt the raters will also point out strenuously) that this rating is not a buy or sell recommendation. It cannot be because it does not take into account the price at which the stock is being offered. In other words, a company's rating will be unaffected no matter how overpriced or underpriced its issue is. This is something I am not comfortable about. It looks like the raters have ducked out of tackling the part which would deliver the maximum value to an amateur investor, no doubt because it would look too much like a straight buy/don't buy recommendation. But this won't work. No matter how strenuously the raters protest, investors are going to take the ratings as a buy recommendations. I think the best by-product of these ratings could be that the kind of companies who are likely to get a 1 or 2 rating may not show up in the IPO bazaar at all. However, the rating process is not expected to include any forensic work so if someone is faking or hiding information then that's not going to get caught.

As with any rating process, there will be some pifalls. As I said, investors could end up considering this rating to be an evaluation to those aspects of a company which the raters do not even look at. But there’s no solution to that. The ratings purport to be a solution to unknowledgable investors. However, there will always be some investors who don’t know enough to even use ratings.

Ideally, I wish IPO ratings were not needed at all but given the actual state of stock investing this is a positive development. My hunch is that if done properly, IPO ratings could develop not into a good preference indicator, but a useful avoidance indicator. That is, investors should use them more as a way of avoiding bad companies rather than selecting good ones. And of course, as always, the really serious profits will come the way of those contrarians who will manage to identify poorly rated companies that are actually good investments.