Investing in IPOs can give good returns, but don't be too greedy

Sometimes, entering the stock after listing helps as it allows you to assess the business model, and perhaps, even get the stock cheaper

It’s often said that investing in an initial public offering (IPO) is fraught with risks. But, once in a while, there comes an Avenue Supermarts (D’mart) issue in which the investor can more than triple his money in less than a year. The stock was issued at Rs 299, listed at Rs 610 on March 21, 2017, and is currently trading at Rs 1,569. No wonder, after an IPO like this, investors start chasing every other issue for supernormal profits. Unfortunately, the result isn’t the same every time. 

Over the past year, 41 initial public offerings (IPOs) of more than Rs 1 billion have hit the markets. Of these, 25 have given positive returns while 16 have given negative returns (see chart). Only 19 of these 41 IPOs, or slightly less than 50 per cent, have managed to beat the returns that an investor could have earned by simply investing in a Sensex-based exchange-traded fund (average return 13.88 per cent over past year). Moreover, if you had bet on one of the poorer-quality issues, you risked ending up with negative returns to the tune of 0.02-32.78 per cent. With another wave of IPOs worth Rs 200 billion set to hit the markets in June and July, investors should bear these statistics in mind before plumping for them. 

Valuations tend to be rich

An IPO is a means through which the promoter tries to earn returns for all the risks he has taken and the hard work he has put in. For early-stage investors in the company, too, this is a time to earn hefty returns on their bets. Investment bankers who help the promoters with the IPO would also like to set the maximum possible price, since their fee depends on how much money they can garner for owners. "All the three parties have a vested interest in setting the price at the highest possible level that the market can bear. Also, most IPOs come to the market during bull runs, when market sentiment is upbeat, and investors are willing to pay higher prices. This means that IPOs are likely to be expensively priced," says Ankur Kapur, founder, Ankur Kapur Financial Advisory Services.

An investor putting money in the secondary market can take advantage of price fluctuations to invest in a stock when its valuation turns attractive. This can happen either when the mood in the entire market is depressed, or when negative news affects the stock of a particular company. If the investor's research tells him that the setback to the company is temporary, he can use the price correction to enter that stock.  

Available information is inadequate

Another risk of investing in IPOs arises from the fact that the financial data available for the company is limited. “To arrive at the correct valuation of a stock requires data of at least the past 10 years. In the red-herring prospectus of most IPOs, you will typically find data for the past three years which is inadequate,” says Bengaluru-based S G Rajasekharan, who teaches wealth management at Christ University and is an avid equity investor. He adds that promoters usually launch IPOs during a buoyant phase in the business cycle – when their financials are looking good. When the inevitable downturn comes, these numbers often take a nasty plunge. Since the investor did not have an opportunity to check the company's performance during both an up- and a down-cycle, he can sometimes get an ugly surprise when he invests based only on three years' data. 

Companies that have been trading on exchanges for a long time are less likely to throw up unpleasant surprises because more information is available about them in the public domain. They have to make disclosures to stock exchanges regularly, even about small developments. Analysts who have been tracking a listed company for a while have a fairly good idea about such qualitative aspects as the competence and character of the management. Such information is not available in the case of new companies.

It is possible to make money, but not always

In bullish market conditions, it is possible to profit from listing-day gains. But, sometimes, if market sentiment turns negative suddenly, or if a stock's valuation is set at a very expensive level, the stock price can plunge on the very first day. Many experts, therefore, regard investing for listing gains as akin to gambling. They suggest investors should avoid such risky bets as the chances of losing capital is high. 

High-networth individuals (HNI) often tend to invest in such issues aggressively. As subscription numbers show, the HNI portion is often subscribed multiple times. If your risk appetite is high, IPOs can give both listing gains, and for the patient, great returns over the longer term. But the trick is to bet on the right ones, and an ear on the ground, so that you have valuable information about the stock’s prospects. 

Retail investors can afford to give most IPOs a miss. Instead, if a stock that has debuted on the bourses appears fundamentally attractive, or belongs to a new sector for which there are no listed alternatives, investors should calculate the valuation at which they will have a high probability of making a profit in the stock. They should then wait patiently for the stock price to descend to that level in the secondary market. Jimeet Modi, chief executive officer, Samco Securities, says that investors should wait for 200 days before investing in a newly listed company. This, according to him, is the time it takes for the IPO-related hype around a company to dissipate and for the price to settle down to a more realistic level. 

Prithvi Haldea, founder and chairman of Prime Database, a company that tracks primary markets, suggests that retail investors betting on listing gains should rely on the response of Qualified Institutional Buyers (QIBs) to the IPO. "If the QIB section is oversubscribed, that usually leads to a price spurt on the listing date," he says. Some comfort can also be gained from the presence of private equity or venture capital investors in a company going for an IPO. According to Haldea, this indicates that due diligence has already been done on the company by a sophisticated institutional investor, so it is likely to have better standards of corporate governance. He adds that it is a good sign if these investors are exiting only partly from the company during the IPO, as it indicates that they see the stock price rising further in the future.