IPOs Sifting through the sand

Rakesh Bhatnagar clicks on a button on his online trading portal and believes that he is guaranteed a handsome return. He now prays to the Lord at Shirdi to help him get allotment for the initial public offer (IPO) of the fledgling tech company. With a little bit of divine intervention, he will offload the allotted shares in the market and gain well -- all in a matter of 15 to 20 days.

Bhatnagar is not the only one queuing up for IPOs. There are many others like him. They are looking at making a quick buck through listing gains, by seeking allotment and offloading the shares on listing when the price is usually higher than the offer price. However, such manna seekers will see such opportunities thinning.


Experts reckon that listing gains will ease further as IPO offerings get priced according to market conditions. It was in 2004 and 2005 when average listing returns were in excess of 50%. Since November last year, listing returns have now averaged at around 23%.

Does this mean that the excitement of investing in an IPO will diminish?

Not exactly, say analysts. There is life beyond listing gains. Rakesh Jhunjhunwala, a savvy investor, when asked about his greatest investing regret said, "The epitaph on my grave will say that I missed out on investing in the Infosys IPO." Infosys, like many other companies, approached the stock market in 1993 with an offer price of Rs 95 per share to garner around Rs 13 crore. The rest, as they say, is history.

IPO revival

Now, while Infosys may be a once-in-a-lifetime story, there are others who have provided extremely lucrative returns to investors. At the same time, there are as many who have duped investors of their valuable monies.

Just about a decade ago, the IPO market was at its pinnacle. In 1995-96, there were 1,428 issues which hit the market. Offer applications of blue chip issues were actually sold in the black market. And after the heydays came hell days. Unscrupulous issuances, along with a faltering secondary market, saw IPOs drying up. The nadir was hit in 2002-03 when there were just about 14 issues.

It took a spate of some strong PSU issues to revive the IPO market. Improved market conditions and overall economic well-being aided the revival. Initially, companies were wary and offered attractive prices. So companies like Saksoft, Gateway Distriparks and Bharati Shipyard offered handsome listing gains. Plucking low hanging fruit became a profitable habit with the investing community. It was this same habit that tempted promoters to tap the market and leverage the euphoria to pass out flawed projects.

Old habits die hard, and ominous patterns are resurfacing. The past year has seen around 100 issues hitting the market. In the previous year there were around 34 issues. This is the highest number of issuances in the past four years. Importantly, the average issue size is the lowest over the same period.

A similar trend was witnessed a decade ago when the number of issuances had peaked and the issue size had dwindled. This trend indicates that there is a rush to gain from the IPO boom. In this rush, many atrocious issues slip through.

And when reality dawned on the investors, considerable wealth had been destroyed. Many of those issuers are nowhere to be seen today.

IPO metrics

It is therefore important for investors to sift through IPO issuances before taking the plunge. There will be opportunities for getting listing gains, but they will be few and far between.

The mantra for investing in IPOs is not different from that of the secondary market. Raamdeo Agarwal, Joint MD, Motilal Oswal, puts it in perspective, "Buying in the primary market is as good as buying in the secondary market." The same holds true in the case of the IPO. There are differences, though. One is that in a fresh IPO, there is no price history or behavior that investors can rely on to get a perspective.

Arun Kejriwal, proprietor of KRIS, and a sharp market observer says, "While investing in an IPO, one should keep his eyes and ears open. One should not fall prey to greedy promoters. One good way is to look at the details about promoters, the business, the revenue model, and the pricing of the issue."

FE Investor lists out some more areas that investors should look at before taking the plunge.

Promoter risk

The promoter is the biggest risk to any project. There might be great projects on the anvil, there will be stupendous opportunities. However, the execution of this project and the delivery of the promise totally depend upon the promoters. Here are some pointers:

• Investors need to look at the track record. Usually, unscrupulous promoters would see that the financial performance dramatically improves in the year of the IPO or just before it.

• Logic dictates that if the business and prospects are so lucrative, why would anybody want to share it with more people? It took many years for TCS to come to the public. And when it came, the reasons were strategic. Investors need to see the strategic need or reasoning in going public. Will the issue add value to the enterprise or simply give some free cash to the promoter?

• Promoters' stake after the issue is critical. A higher share after the issue shows belief in the project on the part of the promoters. A seasoned fund manager suggests, "See if the promoters are willing to eat what they cook."

• Many promoters use bonus issues to grow their own shares and issue bonus issues to themselves just before going public.

• Then there are promoters who have floated several firms and companies in the same line of business. A recent real estate developer from north India offering shares has more than 50 companies in similar businesses. This causes a severe clash of interest where promoters could actually divert high margin businesses to the privately owned firms.

• Where there are consistent performances, check for the return on capital employed. It should be better than the return available in the market at reasonable risk, say around 12 to 13% per annum. The reasoning, analysts believe, is that promoters could be better off lending money in the market at reasonable risk than building an enterprise.

Business outlook

Sound promoters have a knack of making ordinary projects deliver. However, they also need to operate in a business environment. There are several external factors that even peg the sound promoters down for a while.

Promoters take no time in tom-tomming the virtues of the business outlook to sell their wares. Investors need to look at these carefully for hype created by promoters. An entertainment company hit the markets in August 2000 at a price of Rs 165 per share for a Rs 100 crore self-appraised project. The promoter propounded the great future of the industry and indicated that global media companies enjoy a price to earnings (P/E) multiple of 75 plus and justified the issue price. The share currently trades at Rs 60.

Price and timing

The promoter may be sound, the business outlook exciting, but what should be the value attached to both these? Nilesh Shah, CIO, Prudential ICICI, gives an earthly insight into IPO pricing, “One should apply the same rule to IPOs while buying a car or any other requirement.”

He indicates the need to thoroughly compare each product offering and take an educated decision.

Age-old indicators like the ability of the company to generate cash or visibility of earnings, comparable P/E ratios and price to book value ratios also need to be looked at. The current and future state of the market sentiment will also provide a strong insight.

Importantly, investors need not be bothered about missing out the allotment in the IPO. Past experience suggests that after the debut trading hype, around 80% of the stocks underperform the Sensex within a period of three months. The secondary market will always offer the scrip at a competitive price.

In the coming days there are many more IPOs getting lined up. Just two companies are planning to mop up a hefty Rs 18,000 crore between themselves.

The IPO market offers substantial opportunities for investors. And for the likes of Bhatnagar, it would require more than divine intervention for gains.

Since the market place is getting crowded, investors will have to sift through the sand carefully to get to the gold.