Pros and Cons of IPOs

by November 7, 2018 0 comments

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When dealing with IPOs, it’s crucial to have a stop-loss strategy, given the volatile and unpredictable nature of IPOs.

The current state of stock market is at best choppy and uncertain, but that has not weakened the resolve of many companies and Government entities to not to make an entry into the stock market via the tried and tested IPO route. However, amid spiralling crude prices and sky-rocketing fuel prices on the domestic front, the uncertain market is quickly morphing into a bearish sentiment. Is this a great time to launch an IPO or better still invest into one? Some analysts are of the opinion that this is a long term investor’s market whereas others are of the view that the current market conditions are anything but investor friendly and should be avoided pending some much required stability and predictability.

The investors in the Indian stock market have always weathered the ups and downs of the market conditions. But of late it is the IPOs which are gaining some attention and most of the time the attention is turning notorious due to many of the IPO offerings bombing on their listing day; so much so that they are getting inducted into the stock market below their initial offer price. There are multiple instances in the recent past when good and profitable organisations, both public and private have shockingly failed to deliver through the IPO route and got badgered on their first day at the stock market. The recently launched IPO of the railways engineering and construction firm, IRCON International (Indian Railway Construction Company) is one such example. Although, it raised Rs 466 crore through public issue and was subscribed almost 10 times, the stock price plunged to Rs 412.95 at the National Stock Exchange on the closing day against the issue price of Rs 475. On the BSE, the stock price opened at Rs 410.30, which was a day’s low, and closed at Rs 416.65, down 12.3 per cent. The intraday high was at Rs 464.40. This for a company that had its order books full, and had explicit recommendations of premier research houses.

Since the past few decades, the IPO market has been anything but a resounding success. Sure there have been a few exceptions but largely it has been a spectacular failure, with a number of high-profile companies falling off dramatically after first sprinting out of the gate. Some analysts have pinned the blame on a poor economic environment, contending that given the uneven macro picture, coupled with all the major indexes being off by more than five per cent over the last 12 months, the landscape was unaccommodating to all equities, let alone IPOs. No question, market fundamentals and the performance of the broader economy will inevitably impact the valuation of any public company. But such talk is a bit misguided with respect to the real reason why recent IPOs have generally failed: The very process for bringing new issues to market is broken, rife with serious conflicts of interests and essentially set up to fail retail investors. Though this might seem like an exaggeration, but is actually worth thinking about.

Let’s look at the mechanics of the IPO process. On a basic level, it’s like flipping a house, but instead of an individual purchasing a home and waiting a year or two to allow the market to go up, deep pocketed IPO investors, conspiring with investment banks, sometimes wait only a few days, once a flurry of public buying artificially inflates the price, before converting their initial investment into outsized gains. In fact the more the stark reality comes out the more the small budgeted common retail investor will surely back out but for that a comprehensive understanding of the IPO system is crucial.

Currently, many retail investors have a very limited understanding of how a company is taken public. Some don’t know, for instance, that an investment bank determines the issue price, not the market. Others aren’t aware that the same investment bank then turns around and provides their institutional clients — typically ultra-high-net-worth individuals and large pension and mutual funds, among others — the first opportunity to buy those shares, well before the general public gets a crack at them. Fewer probably realize the stakes for venture capital firms, who, having plowed large sums into these companies in the years leading up to their public debut, are eager to cash out their restricted stock once the six-month unlocking period expires.

Working together, all these factors stack the deck against the average investor, who is basically a dupe in this entire scheme. Many don’t realize that they are being used like this, and what’s worse, it’s as if they don’t care. What matters to them is that a hot, new IPO is about to hit the market, and they want in, and no valuation is too high, because in the short-term at least, they all go up. Since investor awareness is very low in India, the IPO saga keeps getting repeated over and over again. This is fuelled by some lucky investors who manage to sell off their stock just in time and make some money.

The retail investors in India like anywhere else in the world are the most risk exposed section of the investing community. Investing in IPOs for these investors can be massively profitable as a hot stock can double or triple in price in a short time. But it can also be equally risky because not all IPOs are born superstars. The retail investor is continuously looking forward to put the money where it would deliver better than bank interest rate. This makes the retail investor community to sometime take risks which ultimately spell doom for their limited funds. IPOs can quickly turn from being awesome stock market investment option to being a rapid method to lose good money in the blink of an eye. IPOs need careful scrutiny by which one does not mean relying solely on the analysis of the research houses which themselves may have an interest involved.

Unlike other listed stocks in the market, IPOs do not have a trading history. There is no way for one to evaluate how the market will judge the stock until it is listed. Buying a stock at an IPO price does not mean that one is buying it at the bottom. It is simply priced according to how much the market is willing to pay based on surveys done among investors by the underwriter. Some IPOs may be perceived to be relatively cheap based on growth prospects while others may be seen as expensive. Until the IPO is finally traded on the stock exchange, one will never know where the stock is going. These are the pitfalls in IPO investment.

Some simple precautions can ensure smooth stock market investment experience, especially the IPO related investments. IPOs can be unpredictable in the first few days of trading. Plan your selling strategy. You can lock in your profits once you have achieved your target returns shortly after listing day. Moreover, unless you firmly and really believe in the IPO stock for long-term investment, take the chance to cash in on your gains whenever the opportunity presents itself. You can always decide to buy it back later when you are more comfortable with the trend of the stock. If you believe in the potential of the IPO and you want to buy more shares of the stock, it is best that you wait for few more days for the stock to settle down before you begin to accumulate.

When a company is going public, underwriters want to make sure that the IPO is going to be successful no matter how unattractive the investment offer. Expect IPOs to be heavily promoted by underwriters because it is their job to sell them to the investing public.

IPOs with familiar brand names sometimes readily tempt us but may not be be necessarily good investments. Although a strong brand recall definitely helps in promoting the IPO, there is no guarantee that the stock will do well once it gets listed. Every IPO has a different story to tell. There are IPOs with good brand names but no solid financials to show. For example, the company may be heavily indebted or operating margins may be below industry average. This has a bearing on how the stock will do once listed. Make sure that before you invest in IPOs you first read the investment prospectus. Find out what the business model of the company is all about.

What is the earnings track record of the company and how will earnings grow further after the IPO? How will the proceeds of IPO help the company expand and monetise its brand? Every now and then, there will always be a chance that you may invest in the wrong IPO stock. When this happens, be prepared to cut your losses. Avoid getting so emotionally involved with the promise of an IPO that you forget to control your risks. Managing your risk is more than investing in the right IPO stocks. It is also about controlling your losses. There are IPOs that steadily decline for months after peaking on listing day. Some simply trade sideways forever with fading volume turnover. It pays to plan your stop-loss strategy early on to protect your investments.

(The writer is Assistant Professor, Amity University)

Writer: Hima Bindu Kota
Source: The Pioneer

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