Fundamental weakness

RATING IPOS

While IPO grading analyses the fundamentals of the company, it's silent on the pricing of the issue. This is a loophole that needs to be plugged.

Investors are always advised that by investing in initial public offerings (IPOs) of good companies, they are going to reap rich benefits.

The Securities and Exchange Board of India (Sebi) also, on its part, has tried to help the investors by introducing mandatory grading for IPOs. This rule, which was enforced from May 1, 2007, allows independent grading agencies to rank the IPO on various parameters.

However, as the recent Reliance Power IPO proved, rating is not a great help. While the grading agencies gave it a strong thumbs up, by a rating 4/5, signifying above-average fundamentals, as things panned out, it listed at a small premium and then, went on a southward trip all day.

Interestingly, during this IPO, not only retail investors, but even seasoned institutional investors, as well as grading companies were proved wrong.

While nobody denied that the company was not bad per se, there was the question of when would the company actually start operations: a good two years later in December 2009. And that does not make great sense for many who want to make a quick buck.

As far as the rating issue goes, here are a few facts. Sebi registered leading credit rating agencies like CRISIL, CARE, ICRA and Fitch to grade equity and equity-related offerings of companies. The rating is done on a 5 point scale, with higher ratings reflecting stronger fundamentals of the issuing company.

The issuing company has to bear the cost of such grading, which will have to be disclosed in all offer documents and advertisements.

The grading is done by the rating agency on the basis of a host of factors, such as the business prospects of the issuing company and the industry it belongs to, its financial position, quality of management and corporate governance levels.

The idea behind such grading is to provide the investor a fair and unbiased view of the issuing company's fundamentals from a reputed rating agency on the basis of the parameters mentioned above, in order to enable the investor to take an informed decision. To this extent the IPO grading system is quite beneficial.

However, the biggest drawback of this rating system is that it does not take into consideration the price at which the issue is being offered. This basically implies that, if a company with good fundamentals overprices its shares, still it gets a high rating. This system is not complete, as it shows the investor only one side of the coin.

Conversely, a new company might actually get a lower rating on the basis of fundamentals. This, despite the fact that the issue might be priced much lower. But if it keeps the pricing very reasonable, investors could still make money in it.

A famous case, during the non-grading days, was the listing of Infosys in 1993. As old hands in the market, the scrip was actually undersubscribed by 10 per cent. The rest, as we know, is history.

In other words, a fundamentally strong company, with a very high pedigree, but aggressive pricing can actually hurt the investor.

Therefore, in spite of tools like IPO grading, the onus still lies upon the investor to take a call on the issue pricing, and most importantly, does he/she like the company for its long-term prospects or wants to make quick gains.

The writer is director, Touchstone Wealth Planners