In a bull market, a higher price-to-earnings in the secondary market justifies higher offer price in an IPO. But sometimes, it leaves very little on the table for the investor.
Less than two weeks into the new year, it's apparent that 2010 will see a great deal of attention focussed on the primary market. In one sense, this is entirely welcome. The primary market is a key driver of entrepreneurship.
There was a long period in 2008-09 when primary issues were entirely off the agenda. Investors were running scared, valuations were low, and promoters didn't care to risk their issues bombing. The return of confidence is a strong indication that the economic recovery is genuine.
The turnaround in the secondary market led to a string of IPOs in the second half of 2009. Large issues like OIL, NHPC and Adani Power all garnered reasonable responses in terms of subscription. The most recent of the lot, JSW Energy and Godrej Properties have both done well, suggesting that sentiment remains extremely upbeat.
In all, around 20 IPOs in 2009 raised around Rs 20,000 cr and the government also took a policy decision to sell at least 10 per cent stake in every PSU that appeared remotely marketable. It seems that both the number of IPOs, as well as the total value of subscriptions raised, are likely to see quantum jumps in 2010.
Some issues will be FPOs (follow-on) rather than IPO, in that many listed companies are looking to sell a second chunk of equity in order to raise more cash. NTPC and L&T both fall into this category, for example as do several real estate majors.
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Going by the spate of filings, there could be well over 100 equity issues in calendar 2010. Around five issues have already been cleared and there are another 40-odd in the pipeline, awaiting Sebi approval. Between them, if all goes well, these 45 issues will aim to raise at least Rs 25,000 crore. That's the agenda for January-March 2010 alone!
The government is said to be targeting IPOs worth another Rs 25,000 crore in unlisted PSUs in the next fiscal. Apart from this host of new PSUs, there are many private companies from all sorts of sectors looking to raise funds. There's a preponderance of real estate players as well as many companies in the energy and infrastructure-construction spaces.
Going by the first lot of filings, there will be a fair number of issues in the Rs 500 crore or less range, since 30 such filings are awaiting approval. That means a fairly heterogeneous mix of large, medium and small issues.
Obviously, each issue will have its own pros and cons in terms of fundamentals and valuations. However, there are several reasons why investors should in general, be cautious, about subscribing to IPOs at all, in 2010.
In the broadest terms, a market with an average of 2 issues a week or even more, is likely to be very frothy. Lead bankers and promoters have obviously swung from being deeply pessimistic to being highly optimistic in the past six months. That optimism is based on the expectation that they can get rich valuations for their offers. This is actually realistic since the secondary market is trading at 23PE and IPO valuations tends to be comparative.
Unfortunately, high issue prices leave very little on the table for the long-term investor. There are three factors that go into making any equity investment decision. One is the fundamentals of the business: Is it well-run, does it have growth prospects, good balance-sheet, etc? A second factor is the valuation: Is the offer price justified, given the fundamentals? The third factor: is there a prospect of short-term capital gains?
Any IPO is difficult to assess in terms of fundamentals because the quality of information and projections in the offer documents can be exceedingly variable. Even if the fundamentals are ok, if the offer-price valuation is high, it's a sub-optimal investment in the long term.
The prospects of short-term capital gains in such situations of high valuation depend on the “greater fool” theory – somebody must be optimistic enough to buy it off you. While bull markets often feature “greater fools”, it can also mean fast dancing to chisel out a profit.
Quite a few fundamentalists advocate avoiding IPOs altogether. Without going that far, I'd be very wary of IPOs made in a bull market. A high secondary market PE justifies a high offer price. You could strike it lucky if you get a bounce upon listing but in that case, you may as well trade listed counters.