NHPC oversubscribed by about 23 times. Adani Power oversubscribed by about 21 times. And there will be a long queue of public issues to tap risk capital in primary markets. Usually IPOs are the instruments through which new retail investors enter equity markets. Why? Because these are advertised on Televisions, Toll check posts, big banners as part of OOH advertisements. We see IPO application forms being distributed as some product pamphlets. Are IPOs really that great tool for new retail investors or the investors which are around for some time to invest in equity? I think they are not! Let me present my thoughts through following points:

The below points are general observations and thoughts. That does not mean IPOs are always bad and should be avoided. Investor has to analyze it on case by case basis otherwise new companies won’t get risk capital for future growth.

1. IPOs come out when there is greenery in the stock markets.

Typically IPOs are floated when there is ongoing bull market rally in secondary stock markets. It’s the timing well achieved by the issuer companies. This facilitates the companies to sell capital at expensive/stretched valuations. Even now a days government is divesting at steep valuations, NHPC stake sold at 38 multiple. So where is margin of safety? There will be little money left on the table for investors to enjoy the gains in public issue. There will be hardly any companies which will value its stocks t fairly, forget the valuations at discounts. Retail investors are better off investing in the company’s peers already listed in stock markets where price discovery has already taken place in much efficient way. There could be chances of bargain price if the company’s future earnings are computed with too much pessimism. Bidding for shares within a price band decided by company, merchant bankers and interested QIBs may not be covering the fair price for the stock. It limits the extent of price discovery process. I recall the concept of transportation of heavy logs of wood being transported through rivers which are originated due to melting of ice at polar region. Isn’t it similar to what happens in IPOs? It could be easier for fundamentally weaker companies to pass through when there is extra-enthusiasm in the markets.

2. Projects financed by IPO proceeds could be more risky.

Diluting IPOs are typically floated to finance the capital expenditures, new business vertical developments; expansion of retail branches etc. When company ventures out into something new, there is inherently higher level of risk involved in successfully achieving the desired results as compared to company doing what it knows best. Company which finances the capex through internal accruals for new business development i.e these investing activities are financed through retained earnings and positive operating cash flows does not need to dilute its equity. If such company is available at lower earning multiples in secondary market why to invest in IPO and expose capital to higher risks that too at stretched valuations? It’s always better to invest in short operating cycle companies with higher net operating cash flows than companies with long gestation periods like power generation company starting fresh without any history of generation or airport development companies.

3. Best investment never goes to investors. Investors go to Best investments.

Best investments are never advertised and are always hidden. These are always smelled out through extensive research by investors when there is element of distress and opportunity inherently in the investment.

4. IPOs are treated as trading instruments by HNIs and FIs.

Within first 2 weeks after listing of stock, its traders’ target. If you like the business and the project to be finance through IPO, it is better to calculate the fair price of the stock and check if issue price is lower than this price with sufficient margin of safety. If the issue price is higher, investor can put the stock on watch list and wait till the traders’ interests vanish. It becomes a investment target if stock price goes below fair price during true price discovery process.

5. The IPO issuer companies are not well covered in research.

The initial due diligence over company assets and business is done by Investment Bankers which have vested interest in success of the issue. Agreed there is SEBI, the watch dog keeping an eye on proceedings. Still full disclosures on business risks, company assets can not be achieved. So it’s always better to stick to companies which are well researched from different angles by various investors in secondary market valuations. I know you are thinking of Satyam exception now.

6. Opportunistic companies could be hitting markets with no candid intention of capex.

Some companies enter primary market just because it’s easy to raise capital in bull market phase. It’s difficult to find out the true/hidden intensions of the issuer. All though it’s mandatory to furnish the usage of IPO proceeds in offer document, there are several instances wherein IPO proceeds are parked in liquid mutual funds or bank FDs for considerably longer period of time. This obviously reduces the ROE for new as well as existing shareholders of the company.

(The article is written by Avinash Bachalkar, our newest strater. We thank Avinash for his post! Avinash is a Senior Engineer at Nomura and did his engineering from BITS Pilani)

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