The year 2017 saw a spate of IPOs hitting the markets here in India. In fact, the number of IPOs that hit the Indian markets in 2017 was unprecedented. For those of you not in the know, an IPO or Initial Public Offering is a situation where a company raises money from the public in the form of an equity stock offering for the very first time. Why then have I called a bull market IPO an Insanely Priced Offering? Read on to find out.
Initial Public Offerings are usually in vogue with investors because they feel it is the cheapest price at which they can buy the stock, especially if the company coming out with the stock offering has promising future prospects, and enjoy all the initial gains on the day of listing before watching it grow into a behemoth. This sentiment is further enhanced during a bull market, which is a stock market phase characterised by strong economic fundamentals and robust economic recovery. Therefore, given this rosey background, investors are all the more enthused when it comes to investing in IPOs and given the fact that global equities are going through a structural and long term bull run right now, it seemingly gives investors all the more reason to celebrate investing in IPOs.
But as picture perfect as all of this may seem, there is a deadly and dangerous dark side to investing in IPOs in bull markets which almost always goes under the radar. Firstly, understand this. When there is a rat race between investors vying for the stock of the latest hot companies on the block, there is an even bigger rat race between the promoters of these companies who look to try and literally extort as much money as they can from the investors looking to be a part of the IPO.Most IPOs in bull markets are fuelled by the greed of the promoters and not the needs of the promoters. Just take a minute to look at it from a promoters perspective. As a promoter coming out with an IPO, I would be raising the money I need from the public at large and not from my own pocket.
When such is the case, why would I bother about what a fair price to float my offer to the public would be, when I know that people out there would readily be willing to pay almost any price for the stock, provided they are sold a promising story? So, I would naturally cook up an incredibly impressive story, sell it hard to the investing public, put an insane price on the offering, before watching the innocent investing public lap up the offering with voracious appetites. Moreover, once the money has been raised, the investing public has no way to clearly find out how the money they have given me is being used. So I can just as well say that I plan to use the money for further expansion, use a fraction of the amount raised for the advertised purpose, just to serve as a smokescreen and pocket the lion’s share of the proceeds myself. And you know what the best part is? There is more than a likely chance that my facade never gets exposed.
Now, I am not saying that every company that comes out with an IPO has a bad promoter or group of promoters with a well cooked story. Some companies do have genuine promoters with genuinely great stories, but even then, sometimes their stock offerings are exorbitantly priced relative to the underlying value of the businesses. It is never a good idea to overpay for a stock, no matter how good the underlying business is. Think of it this way, you may be buying the latest Ferrari model on the block but that doesn’t mean you pay a price worth two Ferrari cars for it. Most IPOs are priced at 3-10 times the value of the underlying business on average, and sometimes even higher.
Most importantly, most IPOs don’t work out as expected. If you bought the Maruti Suzuki IPO in 2003 at 125 rupees a share, congratulations, you’re close to making 90 times your money with the stock at 8750. If on the other hand, you had bought the Reliance Power IPO for 450 rupees a share in 2008, I can only hope you aren’t holding on to it even now with the stock at 35 rupees a share. And this is the story of most IPOs. For a given set of 10 IPOs you may find one or two sucesses, with eight or nine being average performers or complete failures. And the worst part about these IPOs is that they see the worst possible degree of price erosion during tough times, which sees the price erode by 50-75% on average from the high point, or even worse.
So then, what is the best possible way to participate in IPOs? I would prescribe two ways to do so. First, you have the option of finding those companies which come out with IPOs during bull markets and have the strongest business fundamentals. Then, wait for the next bear market cycle, when prices erode heavily thanks to the tough times and negative sentiment around. At this point it is relatively safe to buy these businesses, because you would be buying it at the peak of the bad news, and at a price point that is closer to their intrinsic values.
If this is not your cup of tea, you can look at buying IPOs which are floated at the bottom of a bear market. This is because, in such a scenario, the IPOs would be fuelled by the genuine need of the promoters and not their greed. Also IPOs at the bottom of a bear market are a sign of an impending cyclical upturn for the stock markets and the economy as a whole, therefore making investing in IPOs in such a scenario a little bit safer. Hope this piece helps you understand IPOs more holistically, thereby allowing you to plan your next IPO investments better, ultimately helping you achieve market beating returns.