IPOs – Chasing Greed, not Value
“Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.” – Walter Schloss, a successful investor, fund manager, and philanthropist.
According to Benjamin Graham, the father or Value Investing, IPOs are almost always a losing proposition that retail investors should stay away from. In his famous book, The Intelligent Investor, Graham concludes that the IPO should ideally stand for “It’s Probably Overpriced”, or “Imaginary Profits Only”, or even “Insiders’ Private Opportunity”.
So, why are IPOs so popular? And why is every new IPO talked about as if it is the holy grail?
A Marketing Gimmick
As with most bad trends that are popular in the financial industry, the root cause behind “IPO fever” can be traced back to misinformation and lack of understanding. To understand how IPOs work, let’s take a look at their mechanism.
In the simplest of terms, an Initial Public Offering or IPO, is the process by which a privately-held company lists its shares in the stock market to make them available to public investors. In most cases, the private company hires one or more investment banks to underwrite the IPO. Underwriting refers to the process where the investment banks determine the fair value of the company, purchase the shares at a pre-determined price and then resell those shares to public investors.
During the IPO process, these investment banks and the company’s owners have only one motivation – to make sure that the shares are sold to the public at the highest price possible. The promoters and bankers build so much hype around the IPO, portraying it as a once in a lifetime opportunity to buy shares of an amazing business at cheap price! Brokers and distributors are provided huge incentives to bring in as many investors as they can. Many of them even encourage investors to subscribe to IPOs with borrowed money!
“It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).” – Warren Buffett, considered to be the world’s most successful investor.
A Risky Proposition
Are all IPOs equally terrible? Definitely not. But most of them are also do not qualify as attractive investments for retail investors. Firstly, IPOs are a terribly risky proposition. Private companies do not have to go through the rigorous screening and regulatory scrutiny that public companies do. So, before a company’s IPO, there is very little information available in the public domain to make informed decisions about the business. You have to rely on the assessment and due diligence of the investment bankers, the same people who are paid to drive up the price of the IPO!
Most retail investors get attracted to IPOs with the lure of listing gains, i.e. making quick profits by subscribing at a discounted price and selling the shares immediately after listing. If the IPO is oversubscribed, then there is a reasonable chance of making short-term profits. But the truth is that risks are also equally high. Most IPOs list at a premium or discount due to market conditions and sentiment, rather than fundamental value. This means that it is very difficult to predict the outcome on the day of listing or a week after.
Also keep in mind that when you subscribe in a popular IPO, it is generally going to be heavily oversubscribed. This means that even if there are huge listing gains, you will only be allotted a fraction of the shares and hence your returns will also be marginal.
The IPO index has underperformed the broad market index over the last 12 years. In 2015, 26 out of 52 IPOs listed at a gain of less than 10%, while 11 listed at a discount. Making quick profits from listing gains is not as sure-shot a strategy as it appears!
Why Take the Risk
The only way a retail investor can create wealth through stocks is by investing consistently in fundamentally strong businesses with a long-term view. There are thousands of listed companies in India and at least a few hundred which provide tremendous long-term growth opportunities. Investing in these stocks with a long historical track record is much safer than betting on new entrants whose value is not yet clear.
Don't fall for the marketing gimmicks that are designed to fatten the wallets of clever investment bankers and businessmen. Invest with patience and consistency with the right plan in place and using the best tools available.