Since the beginning of 2021, the IPO market again came into the limelight. The market witnessed a hoard of companies reaching out to the public for funds. The bull run and highly valued market lead to pricey offers. Subsequently, in the cases where the company’s business growth prospects do not support valuation, shareholders witness an erosion in wealth. Therefore, we must evaluate a few critical questions, such as – should you invest in an IPO or not? Do and don’ts of investing in an IPO? Is IPO all about listing gains? Are the IPOs risky investments?
What is an Initial Public Offer (IPO)
In an Initial Public Offer (IPO), private companies offer their shares to the public. IPO is also an exit route for existing shareholders allowing them to unlock the initial investment, often at a premium.
At the time of an IPO, there can be (1) a fresh issue of equity shares, (2) an offer of existing shares (aka Offer For Sale) by the current shareholders, or (3) a combination of both.
Primarily, there are three types of offers:
- New offer – where a company is raising capital for the first time. The IPO proceeds act as a source to inject money into the business
- Offer for sale (OFS) – when the promotors or anchor investors sell their shareholding through an IPO. An OFS does not require any fresh equity of shares. Therefore, only the shareholding pattern changes pre and post the IPO
- Follow-on offers – where an already listed company issues stocks. The follow-on offers can be dilutive or non-dilutive. For example, when a company gives new equity shares, the Earnings Per Share (EPS) reduces. These are dilutive offers. Alternatively, a company can offer already existing shares of the company. These are non-dilutive.
Share allocation methodology
Often you would have heard or experienced that two people applied for an issue, and one person got the shares while the other did not. Ever wondered why this discrimination when all else is equal, or what is the criteria to allot shares to retail investors?
There is absolutely no discrimination, no subjectivity in the share allocation process. The process is entirely transparent and is highly regulated. There is no mystery, as many newbies tend to believe. Every company follows a scientific and impartial way to allot shares. Read more about the IPO share allocation methodology here.
Why do companies offer IPO?
Companies have to raise funds from the public, and there are more than just a few reasons.
First, promoters have limited funds to pump into the business. Alternatively, the company’s original advocates may only be interested in remaining invested for a specific duration or initial phase. Such investors need an exit route, which the IPO provides.
Second, debt funds come with a fixed cost. Therefore, when revenue is still growing, and operating expenses are higher, incremental fixed costs like an interest cost are unnecessary.
Third, rationalizing growth due to lack of funds or putting a cut over expansion plan at the early stage is detrimental and hence not recommended. Expansion here could mean higher marketing spend, more spending on research, entry into newer geographies, acquisition or even product diversification, etc. Therefore, an IPO becomes a necessity to inject funds into the company.
Fourth, IPO is an ideal way for retail investors to participate in the growth of an enterprise.
Finally, listing the company on a stock exchange is one of the best ways to improve visibility and realize the actual brand value. IPO also provides an opportunity to enhance market capitalization.
How have recent IPOs performed?
We analyzed the performance of IPOs listed on exchanges during the first quarter of 2021. It has been a mixed bag with a positive tilt. Out of the 14 IPOs analyzed, four-fifths delivered ~30% listing gains (highest price on a listing day vs issue price). In addition, eight out of ten IPOs witnessed a price increase (as of June 7, 2021) compared to the issue price.
Interestingly, half of the IPOs currently trade at a price higher than the highest price on the day of listing. And, this essentially means, half of the IPOs trade at a price lower than the highest price achieved on the listing date.
Below is the summary table for reference:
Bear in mind, the performance analysis is for a shorter duration, and results can materially differ over a longer course. Further, the market has witnessed a bullish trend. As of Jun 7, the broader market index (BSE500) has grown 17% and 8% since Jan 1 and Apr 1, respectively. (Source BSE India)
In conclusion, we believe companies with a robust business, strong promoter reputation and sound corporate governance practices do outperform over time.
What to look for – five tips for investing in IPO
Let us begin by understanding what is a company and then delve into what to look for before investing or the tips for investing in IPO.
What is a company?
Section 2, sub-section 20 of The Companies Act, 2013 defines a company. It states that a company is a company incorporated under the Act or any previous law.
Simply put, a company is:
- An entity formed by individuals (aka promoters)
- who engage in legal business activity
- to grow the business operations
- enhance the shareholders’ value
- and positively contribute to society
A careful look at all these individual segments provides the answer to what one should look for in an IPO.
Top five tips for investing in IPO
- Dig deep into the pedigree of promoters, their background, and experience in running the business. Further, the quality, stability and credibility of the senior management also plays a crucial role in the future success of the organization
- An understanding of the sector and peer companies in which the business operates is vital. For instance, an examination of the past performance of peers and their operating margins provide valuable insights. The offer document (prospectus) provides this information in a significant detail, therefore, reading the same is essential
- Details of the institutional investors like private equity and venture capitalist will indicate the interest of professional money managers in the company. Similarly, lineage of anchor investors and their past investments can offer a great deal of insight
- Management that applies strong corporate governance practices will attract attention. Investors will put their bet on sound governance and ethical business practices. In addition, every company should consider the impact on the environment and adopt sustainable ways of working. ESG investing will gain increasing importance in India’s investment landscape. Read more about the future of sustainable investing in India here
- Be cautious before investing in IPOs; there is always uncertainty attached to IPO investing. Investors must exercise due caution and adequately analyze the purpose of the issue before investing.
IPO is a risky asset class
An investor’s risk appetite decides the investment strategy. Unfortunately, limited information about the new company and inadequate disclosures limit the thorough evaluation of the performance of the IPO company.
Therefore, retail investors with low-risk tolerance should ideally stay away from IPOs unless there is a compelling proposition. Further, never chase oversubscription; instead, purchase fundamentally strong companies.
To practice, this advice is not straightforward, especially during the bull market. The expectations of listing gains are pretty high. So investors go with the flow and invest beyond their permissible risk tolerance limit. These actions may eventually lead to capital erosion.
Limitations of an IPO
- The quality of financial reporting may not be at par with the listed peers
- IPOs are an exit route (or a part exit route) for promoters and early investors. The issue price may be highly-priced and at a significant premium
- Limited information to gauge financial strength and operating cadence
- Due to the lack of details, a considerable emphasis is on the study of sector and peer performance to draw inferences
Instead of applying for highly-priced IPOs, you may invest in an already listed company. Select a company operating in the same sector and available at an attractive valuation. Or wait for the right time to purchase a new company’s share. The market will value every company at the right price. Any unreasonable premium, because of euphoria in the market or substantial marketing spend, will erode at a later date. The market provides ample opportunities to participate at the right price. Just wait for that.
Do’s and don’ts of investing in an IPO
The IPO market recently witnessed heightened activity at the start of 2021. We expect the trend to continue as the market remain bullish.
Investing in the equities asset class is risky. Consequently, investing in IPOs is even dicier. On top of it, retail investors often consider the IPO a medium to make quick money through listing gains. All this makes it inherently essential to understand the below stated dos and don’ts of investing in IPOs.
- Take a holistic decision based on your personal financial goals and risk appetite
- Always rely on your knowledge before investing, and in case of doubt, engage with a financial advisor. Ignore unsolicited advice, word of mouth appreciation, rumours and any unauthentic source of information
- Read the prospectus (aka the offer document or the prospectus) carefully to know about the industry, business prospects, and the purpose of the IPO
- Check the IPO grading issued by a SEBI registered credit rating agency
- Conduct background research about the company’s promoters, anchor investors and peer companies
- Above all, seek value from investing and not quick money
- Keep exceptionally high expectations from IPOs. Maintain reasonable return expectations, just like any other riskier asset class
- Do not submit to the discount offered to retail investors on the offer price. Even after the deal, the offer price can be high
- On no occasion borrow money to invest in an IPO. Stock prices fluctuate (up and down) based on market conditions. During a decline in markets, IPO investment values will also witness a decline. After all, investors should not end up in a trap by investing borrowed money
- Do not make investment decisions based on emotions or market euphoria
- Never get distracted by giant advertisements and suffer from the fear of missing out on an opportunity. Do not succumb to greed of participation
- Stay away from impulsive investing decisions. High profile or big-sized IPOs do not promise more significant returns. In other words, do not get swayed away by the glitter
- Never engage in unauthorized trades outside the stock exchange (grey market)
How to apply for an IPO issue?
There are two methods to apply for an IPO.
- Offline method – fill in the application form and submit it to the broker or IPO banker
- Online method – make an online application through the online trading portal offered by the broker/intermediary. The portal links to your Demat account, and therefore it is a simple way
In the case of payment, the ASBA (Application Supported by Blocked Amount) procedure gets followed. It means that your IPO application money is only blocked in the bank account. In other words, no amount is deducted at the time of application. Only if the shares get allotted, the amount gets deducted. Else, the blocked amount is released.
Bottom line – should you invest in an IPO?
Based on an investor’s risk profile, allocable funds should get distributed across different asset classes. For the investors who can invest in equities, IPOs can be an integral part.
IPOs provide a unique opportunity to participate in the growth of a reputed enterprise with a robust business model. As a result, an individual’s wealth enhances when the company grows and expands its market capitalization.
A thorough analysis helps the investors to identify the right IPOs where they can participate. But, at the same time, it is critical to invest at the right price. Therefore, if the valuations are high and not supportive of the business it represents, it is better to wait.
In conclusion, the strategy to participate in IPOs must be exercised with reasonable care and diligence. IPOs are risky, but on the other hand, they can provide a significant opportunity to grow investor’s wealth.
Happy investing in IPOs!!
About the author
The author is a senior finance professional with over fifteen years of work experience in corporate finance. He has an affinity for matters relating to personal finance and investment management. Through his writing, the author wants to share his knowledge and understanding of the subject.
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