5 Reasons Why you Should not Invest in an Initial Public Offer or IPO

“An Initial Public Offer of a Company A listed at 50% premium”. This news was shouting loud in my ears from the front page of the leading business newspapers. After few days another one read “An Initial Public Offer of Company B listed at 30% premium”. In recent past, it became a trend for an Initial Public Offer to list at minimum 30% premium. It is bare minimum now. Any Initial Public Offer listing at less than 30% means, the company is not doing well :).

Now you must be wondering have i gone crazy suggesting readers not to invest in Initial Public Offer. Just to add that this post is mainly for investors not for traders. If you are investing in any Initial Public Offer just for listing gains then you can gamble with your money. But luck will not be on your side always. An example of L&T Infotech is sufficient to prove my point. Therefore, the gain in two IPO’s and loss in one might be enough to wash out all the gains. It is as good as gambling or theory of probability. Wherein the probability of success is 50:50.

This post is not about the probability theory:). I will discuss the 5 reasons why you should not invest in Initial Public Offer. On the contrary, there can be 5 reasons to invest in Initial Public Offer. Again to clarify that it is important to understand the concept of IPO beyond the listing day gains :). The most critical point i will share in the last i.e. Point No 5 in the following section.

5 Reasons Why you Should not Invest in Initial Public Offer or IPO

1. Oversubscription:

Normally the newspapers report subscription data when the IPO is open for subscription. It is one of the critical barometers for retail investors to decide whether to invest in an Initial Public Offer or not. In other words, if the IPO is oversubscribed, it is concluded that there is a great demand for IPO thus listing gains are assured. A retail investor also assumes that company is financially sound  thus worth investing.

All the assumptions linked to over-subscription are wrong. Though i cannot divulge too many details in this post but trust me companies hard sell their IPO’s to make it a success. An investor should be cautious about PSU IPO/OFS (Offer for Sale) because of the cross-holding structure. It’s like PSU A invests in PSU B and vice versa. In other words, artificial demand is created.

In one of the instance, the Initial Public Offer was oversubscribed but when i checked the breakup, it was surprising that Retail segment was subscribed only 0.38x. In short, there was a weak demand from retail segment. Therefore, as an investor, you should check subscription figures for QIB, Non-Institutional Investors, and Retail Investors. This data should not be the deciding factor for retail investors. It should be taken with a pinch of salt.

Besides subscription data, some of the retail investors also rely on grey market premium to gauge the demand for Initial Public Offer Issue. My personal observation is that grey market premium is also not a reliable indicator. It is very dynamic and keeps changing. In one of the case, the grey market premium of Rs 90 was wiped off in just a single day. The reason being, a news report that company’s promoters siphoned off dividend just before the IPO issue.

To summarize, if the issue is oversubscribed 11 times then it does not imply that it is good for investment. There can be multiple factors behind the same. It is not feasible for a retail investor to understand the nitty gritty behind the same.

2. Change in Sentiments on the day of listing:

To avoid speculations, now the IPO listing timeline is reduced to 6 days from the date of closing of Initial Public Offer. Still, i feel that one week is too long time for sentiments to turn upside down. One of the common observation is that if the overall market sentiments turn bearish from bullish then the retail investor is stuck in IPO. This is especially risky if you invested only for listing gains. Even temporary reversal of sentiments can impact returns negatively.

3. Companies prefer to Launch IPO’s during BULL Market:

There is a famous saying that you should always ride with a tide. The Initial Public Offer of most of the companies is launched/issued when the market is in a BULL Phase. During Bull phase, the market sentiment is Risk On i.e. investors are willing to take equity exposure/risk for better returns. It defies the basic principle of Stock Investment.

The stock market crash expose the vulnerabilities of the IPO stocks as we observed in past. An investor is caught unaware in such scenarios. The over-subscription during a bear market is more meaningful compared to over-subscription during the bull market. Personally, i avoid IPO issues during BULL market.

4. Valuation of a Stock:

Another mistake by retail investors is that they don’t pay heed to the valuation or Fundamental Analysis of a stock. You may consider upper price band of the initial public offer for fundamental analysis. One of the limitations of an IPO is that you don’t have data points for technical analysis. Though it is but obvious because the stock is yet to trade in the equity market.

As per my personal analysis, out of 10 IPO’s in recent past, almost 8 companies demanded rich valuations from the investors compared to their peers or industry trend. I always compare the valuation of a company with peers/sector. In certain cases, the company is first one in the area of operation/sector like an Initial Public Offer of Syngene. In such cases, there is no precedence for comparison. Some of the experts also compare the valuations with international peers. In my opinion, it is not a correct analysis as Indian equity market is completely different.

5. The Purpose of raising Capital:

As i mentioned earlier that i am reserving most crucial point for the last. It’s a known fact that IPO is one of the most effective and easiest ways to raise money for the company. In my opinion, it is absolutely critical to understand what is the purpose of Initial Public Offer issue by the company or a corporate. The companies raise capital with either of the following 2 key objectives

(a) For Expansion or Growth of the company: It is also called Growth Capital. For example, an IPO of Syngene was launched to raise capital for R&D and setup new manufacturing facility.

(b) Exit route to the promoters/existing investors: If as a promoter of the company, i would like to liquidate part of my holding or investment in the company then Initial Public Offer is an easier route for me. Therefore, Initial Public Offer provide an exit route to the promoters or existing investors. Last year there was a lot of buzz on the listing of one of the leading e-commerce companies in India. The reason cited by experts was that some of the investors would like to exit the company. An offer for sale qualifies under this category.

Recently, i was going through a news report. I was shocked to know that among all the IPO issues in last one year, only 1/3rd raised Growth Capital. Balance 2/3rd only provided an exit route to the promoters or investors. Personally, as an investor, i avoid IPO issues that provide an exit route to the promoters or investors. From an investment perspective, if the purpose of raising the capital is growth capital then the stock is expected to perform better in the long run.

As a smart investor, you should give a thought that if the promoter/investor is exiting the company then why you are entering? It’s like selling off the family silver by the promoter.

Words of Wisdom:

Some of the IPO’s may be good for making some quick money on the day of listing. If you are a serious investor then you should do basic research before committing your hard earned money. In few cases, the companies fundamental are sound but seek higher valuation at the time of Initial Public Offer. In such cases, you may enter the stock in secondary market rather than subscribe to Initial Public Offer in the primary market. There is a probability of getting the better stock price in the secondary market.

I agree that it quite tempting to invest in Initial Public Offer when the media/news reports/reviews are positive. As an investor, you have to differentiate between paid reviews and genuine reviews. As i shared in my post, Stock Investor – 11 Golden Rules For Beginners in Stock Market that you should always read newspapers or go through sites those are free of PAID reviews/news/analysis.

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