IPO: Imaginary Profits Only?

At a glance

  • IPOs or Initial Public Offerings occur when a company “goes public” by raising money from the broader market in exchange for a percentage of ownership
  • Higher the price at which they offer each share of their enterprise, higher is the overall valuation of the firm and in turn the business promoter’s networth
  • Historical data suggests that the number of IPOs increases as markets approach historical peaks
  • A large percentage of companies see significant corrections from their IPO prices which makes it extremely difficult for an investor to make positive returns while investing in IPOs
  • The calm investor is better served by waiting for prices of promising companies to correct from their IPO prices and buying from the secondary market rather than invest in the primary offering

“Somewhere in the middle of the bull market the first common-stock flotations make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues, this brand of financing grows more frequent, the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history.” – Ben Graham (Excerpt from ‘The Intelligent Investor’)

First, a short primer on the Initial Public Offering (IPO). An enterprising young man sets up a restaurant by borrowing money from family and friends and proceeds to make it a roaring success. Knowing there is more demand for the experience he offers, he uses some of the earnings from the 1st outlet in addition to more borrowing to set up the 2nd. As he looks to expand this to become a national chain, he’d like to

  • monetize some of the value he has created in setting up and running a successful business and
  • raise funds in the cheapest possible manner to fund expansion

The Initial Public Offering (IPO) is a means for these two objectives.

After germinating and running a promising business, being able to build enough credibility to invite interest from thousands of retail and institutional investors, counts as a landmark event for any business. As opposed to buying shares on the secondary market, IPOs hold special symbolic significance for investors too, since the price paid flows directly to the company (and its promoters) to fund its next growth phase.

In ‘What moves stock prices in the long term‘ we took a simplistic look at how the business, and therefore the IPO share price could be valued. Even in that basic example, we see a large range in the appropriate value of a share depending on the assumptions in place. Unsurprisingly, the intent of the promoters behind the business is to maximize the price at which they distribute ownership.

Three reasons why investing in IPOs has traditionally been a risky proposition:

Moral Hazard

For a stock transaction to occur there has to be a difference of opinion between buyer and seller on the value of the stock, with the seller thinking of the price as being close to its maximum value and the buyer thinking of that same price as being close to the minimum. In an IPO, as owner, the seller has significantly more information about the inner working, challenges and potential for the business than the buyers. Therefore, logic suggests, when it comes to the disagreement on the value of the company, the very person who founded and is running it is more likely to be right compared to the buyer with sketchy information

A corollary to moral hazard: ‘Marketing push

Most firms rely on investment bankers to ‘underwrite’ and take them to market. These investment banks tend to make a sizable slice of the money raised (upto 7%) from the primary sale. This also means that a lot of concerted marketing goes into convincing an investor to buy a share in an IPO compared to the secondary market. Therefore the chances that a questionable issue will be packaged as the next big opportunity are not insignificant.

IPOs and market sentiment

When is it a better time to wheel out the lemonade stand, at 6pm as the air gets cooler or at 2pm under parching hot conditions? Just like that, IPOs are usually timed to coincide with rising markets and increasing investor appetite. As existing shares climb new highs, investors often pile into every new issue in the hope of getting in cheap.

Chart shows number of IPOs by month over the last nine years superimposed on the NIFTY.

10 IPO

  • In the secular bull market from Feb 2005 to Feb 2008, Indian markets saw a steady stream of new issues every month with as many 17 new issues in some months as the NIFTY kept trending up
  • This stream dried up soon after the drop in 2008 when promoters and investment banks knew they would struggle to get optimal valuations for their offerings
  • As markets recovered, the market for IPOs has also recovered with 18 IPOs in Oct 2010

Dismal historical results

IPO

Finally, a look at the returns that new issues have offered over the same period is educational. Chart shows the returns on shares bought at IPO prices for 460 new issues compared with current (March 2014 prices).

  • Of the 460 new issues from Feb 2005 to Feb 2014, 344 (75%) have declined from IPO price since listing. Note that the majority of new issues are older than 2008
  • 199 new issues (43%) have lost over 3/4th of their value since listing
  • 38 new issues have retained their value and given returns between 0 and 25% aggregate
  • 154 (33%) have showed price appreciation over IPO price with 15% having delivered returns of over 75% since listing

Something to consider as one of the latest IPOs, Wonderla, an amusement park business, has been oversubscribed by 38 times the available shares.

The point of this article is not to dismiss all new listings, since some companies provide excellent opportunities to invest at a reasonable price but the typical timing and incentives of IPOs mean that the calm investor needs to be doubly sure about the value of a new listing

 

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