Evaluate company's fundamentals and valuation before investing in IPO

If the firm is of a sound quality but the valuation is high, wait for a price correction

Individual investors sold more than 50 per cent of shares by value allotted to them in initial public offerings (IPOs) within a week of listing, and 70 per cent within a year, according to a recent study by the Securities and Exchange Board of India (Sebi). The study compiled data from 144 IPOs listed between April 2021 and December 2023.

 

Lure of quick gains

 

Experts cite several reasons why retail investors adopt such a short-term approach. One, most investors do not have the skills, nor do they dedicate the time and effort required to analyse every IPO in detail. “Since investors lack conviction in the IPOs they invest in, they are unable to hold on to them for the long term,” says Deepak Jasani, head of retail research, HDFC Securities.

 

He adds a couple more reasons. “Most IPOs are offered at high valuations. After listing, many of them fall in value. Investors want to avoid this situation and hence exit early,” he says.

 

 

During a bull run, a large number of IPOs tend to offer listing gains. “Most retail investors do not understand the fundamentals of the company, nor do they read the red herring prospectus. They are just betting on the fact that they will get listing gains amid the bullish market environment,” says Ankur Kapur, head of investment, Plutus Capital.

 

Many investors also wish to rotate their money into other IPOs. “The reduced timeline for IPO listings means that investors can quickly assess their positions and reinvest their capital into new opportunities,” says Sarvjeet Singh Virk, co-founder and managing director of Shoonya by Finvasia.

 

Short-term view

 

Short-term bets on IPOs carry risks. One is that there is no guarantee every IPO will open at a premium. “Sentiment and narrative can turn at any point, and an IPO can list at a discount, causing losses,” says Kapur.

 

High valuations can also result in a price correction, once the excitement around the IPO dies down.

 

Short-term bets also carry an opportunity cost. “If the stock becomes a multi-bagger in a few years, investors do not reap the benefit of that appreciation,” says Jasani. He points out that selling a stock after holding it for a very short period means paying the higher tax rate of 20 per cent on short-term capital gains.

 

Investment horizon

 

While there are no hard and fast rules regarding the investment horizon, Virk says more confident and seasoned investors may hold the investment for the long term.

 

Kapur believes that, as with any other equity investment, one should invest in an IPO with a minimum horizon of three years, though five years or more is ideal. “Only with that kind of horizon will you earn meaningful returns,” he says.

 

Investors must realise that IPOs carry more risks than stocks listed on exchanges for some time.

 

 

“These are new, untested companies. In the case of companies that have been listed for a while, history is available on the management and its corporate governance practices. Analysts also have insight into the kind of earnings guidance that the management gives and whether it is actually able to achieve it. That kind of history is not available for the management of these companies,” says Jasani.

 

IPOs are typically launched when a company’s performance looks good. “If the company is facing difficulties, it will not make that information public. Moreover, the IPO investor might enter the stock at the peak of the company’s business cycle, after which things may go downhill,” says Jasani.

 

Unlike established companies, IPOs lack a comprehensive track record of financial performance. “Investors must rely on the limited data provided in the prospectus, making it challenging to assess the company’s profitability, stability, and growth potential,” says Virk.

 

Investors should also be aware of the information asymmetry that prevails in IPO investing. The promoters and early institutional investors sell and exit the stock, either partially or fully. Uninformed retail investors, who do not understand the business, have not read the prospectus, and have not evaluated the company’s performance, are at a disadvantage. “The seller is stronger and better informed, while the buyer is weaker and uninformed,” says Kapur.

 

IPOs are usually offered at high valuations so that promoters can get the maximum price for their shareholding. “The high valuations reduce the odds of retail investors making money on IPOs even over a longer horizon,” says Kapur.

 

Wait for right valuation

 

Once the company has been listed for three months to one year, the reality begins to emerge. “Even if it is a high-quality business, there is a good chance you could buy the stock at a lower valuation six months to one year down the line, once the euphoria around its listing has evaporated. A market downturn may also provide an opportunity to enter the stock at a more attractive valuation,” says Kapur.

 

What should investors do

 

Research a company’s fundamentals and assess whether it is worth investing in

 

Stick to companies with strong fundamentals that you can invest in for the long term

 

Determine if the company’s valuation is reasonable. If it seems overpriced, wait for a price correction which may offer a better entry point after the IPO listing

 

What should they avoid

 

Don’t invest based solely on tips from friends or colleagues without doing your own research

 

Avoid getting influenced by market trends or excitement surrounding a popular IPO

 

Be cautious about companies that are not yet profitable, as it can take a long time for them to show a profit

 

If you’re unsure about the company’s value, don’t feel pressured to invest during the IPO phase