The lure of something new attracts us as humans, and this extends to the stock markets. Specifically, an IPO (Initial Public Offering) or the listing of shares of a company that was previously unlisted.
Investing in IPO: Exercise caution before you take a plunge
Experts note that IPOs may be approached but with caution, research and knowing your investment priorities. Read more as experts give some suggestions on how to approach the IPO market for the retail investor.
But, experts caution that this may be a case of thinking twice and approaching with great caution.
“No. It (investing in IPOs) is not safe. It is a clear avoid, for the retail investor,” says Kishor Ostwal CMD CNI Research Ltd. He notes that IPOs are basically to show large subscriptions and thus listing gains, rather than long-term benefits.
“The risk of investing in the IPO market has increased in 2021-22,” says Vinod Nair, Head of Research at Geojit Financial Services, who notes that the risk appetite of small investors is low, and the safety of their capital is the priority.
There are inherent risks with this asset class as with any in the equity universe.
“This asset class is fraught with Liquidity risk, as the liquidity event (IPO) may get delayed due to adverse market situations. Also, there is no mechanism for price discovery in private markets and pre-IPO deals as the share price is far less correlated to fundamentals”, said Rahul Bhutoria, Director and Co-Founder, Valtrust.
“The biggest flaw of the recent IPOs is that the majority of funds raised in an IPO does not go to the company but goes to private equity,” says Ostwal. When the existing shareholders do not have confidence in the company (the reason for the selling in the first place) how can small investors can muster confidence, Ostwal asks.
“When the low interest rate and high quality fuelled the bull run in the year 2021, and IPOs gave spectacular returns, investors were seen to be chasing the upside even when the allotment was becoming difficult,” said Mr. Prashant Joshi, Head Family office Practice, Upwisery Capital Advisors Llp.
This was the time pre-IPO suddenly became an asset class that one must have in the portfolio. But with the rise in interest rates globally there has been a sharp correction in valuations. The crunch in liquidity has propelled the unlisted companies to delay their IPO plans due to drop in valuations. Thus, the investors with pre-IPO investments have their fingers”, says Joshi.
According to data compiled by a prominent broker, “As of 30th December 2021, out of the 65 IPOs in 2021, 45 gave positive returns, and 20 gave negative returns. Out of the 65 IPOs, 15 IPOs delivered over 100 percent returns”.
It may be noted that there is no mechanism for price discovery in private markets and pre-IPO deals (as opposed to the secondary market) as the share price is far less correlated to fundamentals; this creates a more significant risk for investors buying at obnoxiously high prices. So you have someone buying Paytm at ₹2500 per share (share price ₹502 on December 1, 2022 in early trade).
“Non-availability of all the information makes it challenging to make an informed decision,” says Bhutoria.
However, experts note that IPOs may be approached but with caution, research and knowing your investment priorities.
Experts give some suggestions on how to approach the IPO market for the retail investor.
“To make it workable (investing in IPOs), small investors will have to make an extra effort to assess the amount of risk they are taking,” says Nair.
Nair notes that the IPO market should be an integral part of an investor in identifying investment opportunities, which can be increased or decreased after the listing of the entity based on valuation and future earnings growth.
“Never go after which is not known because IPO means Initial Public Offering hence the background and part record cannot be checked. Also go for IPO where IPO proceeds will be for project or reduction of existing debt and they should not be scapegoats of other investors exit,” says Ostwal.
“For that matter I will not fancy even an offer for sale by the promoters as the money will go to the promoters and not the company,” Ostwal says.
“There are opportunities when markets are subdued, and one can capitalize on them by entering at a lower valuation,” says Bhutoria. As in any equity class, asset allocation is the key, and illiquid investments like pre-IPO and unlisted shares should be at most 5% -10 % of your portfolio.
There are certain red flags that an investor can look at to make his/her investment decision or avoidance in an IPO.
Thus, small-sized IPOs, like SMEs and low-ticket size companies are usually of high risk, even though they may be priced low. Low or no anchor investors ahead of the IPO reduces the lucrativeness of the offer.
“Majority of OFS (offer for sales) with low or no amount of internal funding for the company is an indication of saturation in growth in business & valuation,” says Nair.
An IPO with a lack of capex is an indication of limited future growth.
Don’t subscribe based on herd mentality, be critical of most advertised and highlighted names in the street. Avoid high debt and low cash flow generating companies. If the reports or RHP lack clarity, avoid such offers.
“An important Red Flag for me is valuations,” says Ostwal.
To illustrate, the Nifty trade at 20-21 PE (price earnings) and many companies have come at 70 to 700 PE. Nykaa came at 700 PE whereas Paytm was in loss. This is just selling a concept at fancy prices, obviously not good for an investor.
There are many stocks which are earning much better trade at PE of 5 to 10 in the secondary market. Also, the clout of merchant bankers, big NHI’s, anchor investors lure small investors.
“An IPO as an exit strategy by promoters and initial investors is a Red Flag,” says Joshi. Non-growth-related utilisation of IPO money like repaying old debts, settling old claims, etc, and significant promoter stake dilution, needs investor attention as there can be several reasons for it, which need to be understood. “Well-performing and/or euphoric markets exude over-optimism, and one should tread carefully in such markets,” Joshi cautions.
IPOs and Research
So if you decide that your IPO is a must, experts offer advice on the sort of research that must be done for investors going into an IPO.
“A detailed investment analysis should consider factors like an understanding of the company’s business strength, growth potential, the purpose of raising capital, utilisation of funds, promoters background, industry/sector growth outlook, and other factors vis-a-vis its peer set which gives it an edge over the competitor, are a must,’ says Joshi.
“Small investors need to understand the offer and match it with their risk appetite, rather than depend on suggestions offered by experts,” says Nair.
Also, remember that there may be a conflict of interest situation with the views offered by the experts. An investor needs to critically analyse the investments of the IPO. The investments should match the priorities and business of the company, otherwise it may be better to avoid the IPO.
Also look at the industries which are investable and not investable, based on the themes of the economy and government policies. Try to look at the USP of the company, industry, and products based on the market share.
Manik Kumar Malakar is a personal finance writer.