No guarantee

Will the public's money be any safer if the market regulator does indeed go ahead with plans to introduce compulsory ratings for initial public offerings (IPOs)?

The answer cannot be an unqualified yes. It is certainly a good idea to ask rating agencies to vet public issues and offer investors expert opinion on their quality. But this does not mean investors will not lose money on IPOs that carry good ratings.

What a rating agency can do is take a close look at the financials and assess the quality of a company's business model or management bandwidth. It cannot eliminate all risks.

No rating agency, for example, can tell investors whether the price paid for the IPO is fair or not. While risks of fraud and non-transparency can be mitigated by a rating, nobody can insure against the vagaries of market expectations and moods.

In the bullish market of 2003-04, most retail investors made some money on IPOs, including the massive public sector offers of February-March 2004. Maruti, whose valuations based on historical P/Es looked rich when it made its IPO around mid-2003, confounded the pessimists and went on to earn huge profits for investors.

Another IPO, that of Biocon, did even better on listing, and now trades at astronomical P/Es, thanks to investor fascination for scarce biotech stocks.

The point to underscore is simple: whether an investor makes money in an IPO or not depends only partly on how the raters evaluate a company, and equally or even more so on other factors such as market sentiment at the time of listing and the demand for the scrip as against available supply. In bad times, even good stocks can lose investors money.

If Sebi is thinking of compulsory ratings for IPOs, it would do well to educate investors first on how to use such ratings. Thanks to years of mollycoddling, retail Indian investors have come to believe that they have a fundamental right to IPO profits without reference to risks. If they don't make money, it must be because some watchdog is sleeping at his post.

In the pre-liberalisation years, the Controller of Capital Issues aided this kind of thinking by deliberately under-pricing most issues. Investment in IPOs was like a sure-win lottery. If you got any allotment at all, you made money. The arrival of Sebi with statutory powers to clear IPO prospectuses gave investors a false sense of security about investment decisions.

Given the kind of losses made by investors in IPOs of the dotcom era, Sebi has faced enormous flak for failing to prevent this massacre. The move to impose compulsory ratings of IPOs can thus be seen as an effort to separate Sebi's role as a primary clearing house for prospectuses from that of an investment advisor.

However, even if ratings become compulsory, Sebi should make it clear that a good rating does not amount to an endorsement to invest in an IPO. Nor does a bad rating mean the opposite. That job can only be done by investment advisors and portfolio managers. Sebi's primary role should be to continuously drive home the point to investors that equity investment involves risk. There is no free ride for any investor, big or small, rating or no rating.