In defense of IPOs: Lessons for the small investors

Prithvi Haldea / March 20

It is so often that I read a press report stating that “most IPOs are currently quoting at a discount because they were overpriced”. Some have even gone to the extent of accusing companies of committing the “cardinal sin of overpricing”, suggesting as if the issuers can price their IPOs irrespective of what the market will accept! Some have also called it an IPO bubble, and are happy that it has now burst.

For the past few months, the media has been full of reports about flooding, poor quality and overpricing of IPOs, supposedly leading to huge losses to the “small investors”. In fact, this had become so exaggerated that it led to the proposal of grading of IPOs, a risk instrument, untried anywhere. The recent meltdown has seen such “loss” analyses only in sharper focus. Regrettably, we seem to be going stray with these biased or half-baked analysis.

Let us examine the facts.

No flooding

First of all, there has been no flooding. Despite the size of our country, coupled with a growing economy and a very strong bullish stock market, the last 14 months, January 2006 to February 2007, have witnessed only 102 IPOs; that works out to only 7 IPOs a month!

No poor quality

Regarding quality of IPOs, it appears that we are still carrying a hangover of the 90s when there was not only poor quality but also aggressive pricing, then easy as the entire issue had to be sold only to the retail, who could be easily hyped. The quality of issues now has improved dramatically due to tighter entry norms and better vetting, both at SEBI and at the two national stock exchanges. Most significantly, half of each issue has to be bought by institutional buyers, who are more discerning. Little wonder, almost all offers have been from established companies; just none from greenfield projects from new promoters. We have had fewer but larger issues. The average IPO size in the 1992-93 to 1996-97 period was Rs.6.96 crore (4,380 IPOs). In the preceding 3 years (2003-04 to 2006-07), it was a huge Rs. 273.19 crore (190 IPOs). Therefore, this time around, there are no vanishing companies; each IPO company is existing, alive and is bring traded.

Rank bad IPOs cannot even reach the investors anymore. Since January 2006, as many 9 companies were forced to withdraw their issue plans by the stock exchanges/SEBI.

The market too can and does distinguish between good and bad IPOs. If some IPOs escape the regulatory vetting, the market rejects them. As many as 6 IPOs failed because of lack of even a one-time subscription. In fact, not every IPO, when the bull market was on, got hugely oversubscribed ; of the 102 IPOs since January 2006, as many as 40 got oversubscription of less than 5 times. Post listing too, with more sense and disclosures, the market does distinguish between good and bad IPOs and hence despite the crash, several IPOs are still quoting at a huge premium (Tech Mahindra, GBN, Idea, Mindtree are some examples).

No overpricing

Now about overpricing. To begin with, all stocks are good or bad, only at a price. Hindustan Lever is bad at Rs.1000; it is very good at Rs.100.

Ironically, there is a recurring demand for abolition of the retail quota in IPOs as it leads to multiple applications because of assured profits due to underpricing . So how can then there be the accusation of overpricing? In any case, overpricing is no longer possible in the new market structure . Prices are now determined through an elaborate pre-issue marketing exercise. Institutional investors to whom half the issue has to be sold compulsorily will not take just any price. Companies, of course, are cautious in pricing – IPO is once in a lifetime event and they have to ensure it sells ; merchant bankers too do not want issues to fail and blemish their reputations and prospects. The bottomline: IPOs have to be bought, they cannot be sold. As an aside, even if we grant that an IPO is overpriced, who does larger amount of funds that have been mobilized? The company and its investors, right, except in the cases of offers for sale where the promoters may enrich themselves, but then there have been hardly any IPOs of this kind.

In reality, issue pricing is a complex subject; there being no one perfect method of valuation. The entire capital market exists because of differing views on valuations. In fact, there would be no capital market if everyone had the same view; in reality at every second, one sells a stock because he thinks it is overpriced, and the one who buys thinks it is underpriced. Issue pricing is substantially about the future -- an unknown domain. Although a few issuers do price their offers on the basis of past performance (historical earnings), most try and rightfully sell their future (forward earnings). Issuers do look at benchmarks available, as analysts and investors tend to draw from such comparisons. Most important of these is prices of the peer companies. But it is difficult to pin issue pricing down to just one factor, as each company is unique. That explains why the issue price PEs (based on historical earnings) of the last 3 years IPOs have ranged from 1 to 382! In the recent past, when the entire market was working on forward multiples, IPOs got priced similarly.

We should appreciate that IPOs can be floated only in a buoyant secondary market as otherwise, there will be no buyers. Quite understandably so. When there are no buyers for the already well-established secondary market stocks, how can there be a demand for the untested IPO stocks? So, in buoyant markets, IPOs will tend to be priced close to peer group, who in most cases would have already seen a rise in their share prices. However, if these get listed during a crash period, it would obviously so happen at a discount, in line with fall in other secondary market stocks.

Generalizations about bad IPOs and overpricing have only marred any logical analysis and created an unnecessary scare. Data clearly shows that IPOs in India have not been overpriced. It is ironic that for two years when the bull party was on, all TV channels and newspapers rejoiced underpricing of IPOs as each one of these listed at a huge premium. Now that the markets are down, they seem have become wise saints and in hindsight proclaim the same IPOs as overpriced! Hindsight can lead to hilarious situations . Let us take two examples-Jet and GBN. Before their IPOs, every one believed these to be overpriced, especially given their loss-making track record. However, both received overwhelming response and both got listed at a huge premium. Now Jet, after months of premium listing, is at a near 50 per cent discount and is accused of overpricing. GBN is still quoting at a huge 125 per cent premium and we admire it for “leaving enough on the table”! The fact is that 98 per cent of the IPOs had “left enough of the table”. The problem is that the investor did not pick up the gains.

Interestingly, if each share of all 95 IPOs that have been listed till date was sold on the respective listing dates, the gain would have been a huge Rs. 9,270 crore on an investment of Rs. 26,776 crore, a phenomenal gain of 35 per cent in just about 21 days! So much for overpricing!

Proof of pricing

Proof of pricing should be based only on two parameters: the level of over-subscription and the listing price. When an IPO receives an overwhelming response, it means that the collective market wisdom believes that it is underpriced. Therefore, an overpriced IPO logically would not sell in the first instance. The second stage of validation is the price on the date of listing. If it lists at a premium, the conclusion of underpricing is obvious. In fact, the market believed all IPOs were grossly underpriced, given the absurd gains post-listing. The real accusation of overpricing, if at all, can come only if listing takes place at a discount in a bullish market.

Post listing performance is still good

I dislike doing any cut-off date analysis of IPO returns, as there is nothing sacrosanct about the chosen period of IPOs or the cut-off date for market prices. But following the shrill concerns voiced by a section of the media on investors making losses due to IPO overpricing, let me put things in a right perspective.

I picked up all 102 IPOs that were made after 1 January 2006 till 28 February 2007 of which 95 have been listed till 15 March 2007. What does the study show? First, except for just three, every single IPO was listed at a premium. The three that are in the negative zone got listed during the post-crash periods.

Focus should be on large IPOs

Moving beyond the listing dates and looking at the current prices, the primary focus should actually be on the larger IPOs, which also mean more investors. The analysts fail to understand that what is critical is the quantum of losses by amount and, therefore, they should not run headlines about losses in some small IPOs. In a Rs. 45 crore Oriental Trimex IPO, where the retail share was a meagre Rs. 15.75 crore, the fall in the share price even by 50 per cent works out a small Rs. 7.87 crore. On the other hand, in the Rs. 465 crore IPO of Tech Mahindra, where the retail share was Rs. 163 crore, the gain today to the retail is a whopping Rs. 650 crore.

So, if I was to look at the largest 15 IPOs of this period, I find that even after the recent market crash, as many as 11 are still in the positive zone , based upon the market prices as on 15 March 2007 (Annexure). Then, why the outcry about the huge losses inflicted by IPOs on the small investors? The four laggards are Cairn India , Parsvanath, Lanco Infratech and Indian Bank. Significantly, even here, except for Cairn, all the other 3 IPOs had given an exit opportunity at a huge profit after listing. Moreover, the loss today on Parsvnath is a meager 8 per cent and on Indian Bank a tiny 3 per cent. On the other hand, several IPOs have provided dream return including Tech Mahindra (299per cent), GMR (85 per cent), Gujarat State Petronet (79 per cent) and Sun TV (69 per cent). In this period, 102 IPOs raised Rs 27,152 crore, of which, the top 15 accounted for Rs 18,880 crore or 70 per cent of the total amount. And if 11 of these have given positive returns, the bogey of IPO overpricing should be laid to rest. Analysts should, in fact, talk about the large IPOs and not unnecessarily create a scare by quoting small, few, inconsequential IPOs.

Going down further, even if one was to look at all IPOs above Rs. 100 crore of this period, of the 44 such IPOs, as many as 26 are still quoting above the offer prices, despite the huge market crash. Even here, each one of these, except one, had given an exit opportunity at a profit on the listing date and even beyond. So the fact is established. Despite the crash, IPOs on the whole even subsequent to their listing have done well.

Going down even further, if one was to pick the current prices of every single of the 95 IPOs that have been listed till date, the number of negative performers at 51 is surely high. But, is that not the case with thousands of secondary market stocks, which have lost huge values after the crash, or even otherwise? Surely, the small and mid cap IPOs have taken a beating quite like their peers in the secondary market.

IPOs do not operate in isolation

Let me, therefore, raise a fundamental question? Do IPOs operate in isolation of the market? Once made, do they not list in the already populated secondary market? The whole market has recently gone down; over 90 per cent of the scrips have seen a huge erosion in their market prices, including many stalwarts like Hindustan Lever, Colgate, Gillette, Tata Tea, Nirma, Tata Motors, Bajaj Hindusthan etc. etc. Why does one not point out fingers at all these already listed companies or at their promoters for having brought losses to the investors? It is patently unfair to expect IPOs to quote above their offer prices at all times and always better the market. The problem is that we in India tend to put IPOs on a pedestal, and expect them to perform well, and till eternity, come what may. This is surprising as IPOs in fact are the riskiest form of investment. Some IPOs will deliver, some would not. That is the nature of business and equity investing. That is also true of companies-some deliver, some do not. It is absurd to isolate IPOs and have screaming headlines about how IPOs, and that too selectively, are quoting at a discount to their offer prices because these were overpriced. Like secondary market stocks, some IPOs will gain on listing and keep gaining, some will gain on listing and fall later, some will fall on listing date and fall further, and some fill fall on listing date but gain later. There are enough examples in each category.

Who has lost money in IPOs?

Has the small investor lost money in IPOs? If he had bought a stock through an IPO, he had an opportunity to book a profit in almost every IPO. (Is the above too simplistic? No. I have personally done so. Except for a very small number of IPOs that listed in the post-crash period - May 2006 and February/March 2007 -, on each IPO, I booked handsome profits by selling on the listing date, yielding gains of between 10 per cent and 250 per cent, and in just under 20 days!) For example, if someone invested in the IPO of Parsvnath at Rs. 300, he had an exit opportunity on the listing date at a whopping Rs. 579. For several days after listing, this stock continued to offer positive returns. The stock then fell not only because of the crash in the secondary market but also because of the re-rating of the real estate industry. In addition, there may have been some developments in the company. If an investor did not sell on listing, he was either greedy (and had hoped for an even higher return) or was lethargic or took a wrong call on the market or the company. So, why blame the IPO pricing? It is the ill-informed investors who have to pay for their own greed or lack of due diligence. And not for “the sins of greedy promoters and reckless investment bankers”.

So, who is losing in IPOs at their current low market prices? Surely, not those small investors who are accused of being flippers who encash the lottery on the listing date. If a few small investors did not sell on the listing date or if new investors bought at the huge post-listing prices, we should not worry for them. Nor for the ‘informed discerning' QIBs or the speculators, who having failed to get any significant quantities in IPO proportionate allotment and, therefore, are the ones who buy post listing.

An IPO is an IPO only till the date of listing

On the other hand, if a small investor bought from the secondary market the stock of a company which recently had made an IPO, he has not bought the IPO but has essentially bought a secondary market stock. Once a stock lists, investing in it is like investing in any secondary market stock. It is time we learnt that an IPOs remains an IPO only till the time of listing Any analysis of IPO returns should be done only at the time of listing, and that too if the secondary market has not crashed in the interim. After that, the stock becomes a regular secondary market stock, influenced by the state of the market, macroeconomic factors and company-specific factors. Any post-listing date analysis is therefore, meaningless because it has then become a secondary market stock. If Lanco, which recently had an IPO has fallen by 26 per cent between 27 November 2006, the date of its listing and 15 March 2007, the already listed and well-regarded stocks have fallen even more: Unitech by over 35 per cent from Rs.544 to Rs.349, Ansal by over 50 % from Rs.1134 to Rs.558, Mahindra Gesco by over 60 per cent from Rs.1300 to Rs.544 and Peninsula Land by nearly 65 per cent from Rs.967 to Rs.358. Hence, for such new investors, there is no ground again to blame the IPO. In fact, every time if one does have to do a current price analysis of IPOs, similar stocks from the secondary list should also be considered.

Retail is not hurt

Though no data is put out by SEBI or depositories on this, the market experts believe that in the present crash, unlike the last one in May 2006, the retail investor has not been badly hurt. I am, therefore, not amused by the agency of small investor protection in this context, as they are not big time investors in the first place. They are believed to have sold out periodically.

The reality is that the retail is no longer enamoured by the capital market. And now not even by IPOs. Prior to the May 2006 crash, IPOs used to attract a large number of investors: Reliance Petroleum (19.39 lakhs), NTPC (13.95 lakhs), TCS (11.62 lakhs). Bank of Maharashtra (9.65 lakhs) UCO Bank (7.05 lakhs) or Petronet LNG (7.14 lakhs). Since then, even the so-referred great IPOs have received very few applications, the highest being Idea (6.20 lakhs) followed by Mindtree (3.59 lakhs), GBN (2.43 lakhs) or Indian Bank (1.77 lakhs). In 6 IPOs, the retail did not even subscribe to their quota. It is the day trader who has been caught on the wrong foot, and why should any one worry for him?

A word about the real estate sector

Let me talk about the much-maligned real estate sector. Let us appreciate that this sector, despite the huge rise in market prices, still constitutes just about 2 per cent of our market cap; worldwide, it is more than 15 per cent. At long last, IPOs from real estate companies are bringing transparency and order to this vital sector. We should not paint the entire sector as black. Nor misguide by generalizing that “several thousand crore of rupees has been raised by such companies” Because in reality, this sector has had just 4 IPOs since April 2005 which have raised only Rs. 2072 crore! (Most confuse construction companies and road-building companies with real estate companies).

Lessons for the small investors

Going forwards, what are the lessons for the small investor when investing in IPOs? He should first decide whether he is investing in the IPO or the company. If it is the former, he should find out that the QIB participation is significant , as it validates issue quality and price. Second, the issue should be large , as that will ensure a large float and liquidity, and allow big investors a chance to invest post-listing. Three, he should sell on the listing date and book profits. And there is nothing wrong in that. Our market has become like that only. If 80 per cent of our secondary market volume is of day-traders, why do we wish that the small investor should hold on to his IPO-acquired stocks? Of course, the only risk he will run is of a market crash between the date of application and the listing date – typically a 21-day risk. On the other hand, if he is investing in the company, he has to study hard, and take a long-term view, and not get into a panic by market fluctuations.

The real need is to address some key problems

The problem why IPOs seem to be getting so much bashing, is not in bad quality or overpricing. In my view, the real problem is that we are not able to contain the various ills of our market, and instead find scapegoats. One such is IPOs. There is an urgent need to contain some serious problems: misuse of issue funds, malpractices in IPO allotments, manual and time consuming IPO process, insider trading, manipulations in trading on the listing date and post-listing. Or if certain QIBs are going awry, then punishing them or even changing the QIB norms. And, also focus on better disclosures to help investors make more informed decisions. It is unfortunate that bad analysis are casting a wrong impression about IPOs, and leading us to such bizarre ideas as IPO grading!

Need is to support IPOs

First time ever, we are witnessing a large number of good IPOs. The capital market is getting its due depth. Time we got the huge unlisted economic activity in the public domain. Time we stop IPO bashing. Time that we welcome more IPOs. Time we changed our mindsets on IPOs.

IPOs : Issue Amount Rs. 100 Crore & Above

Period :January 1, 2006 onwards

SOURCE: PRIME DATABASE

(The writer is chairman & managing director, PRIME DATABASE)

'PricewaterhouseCoopers' study on Mutual Fund industry'

'Opportunities are plenty, challenges galore before MFs''

Vinay Ranjan / June 25
The product differentiation and quality standards would be the key enablers that could make a difference between boom and gloom for the fund houses. “Opportunities are aplenty and challenges galore", said the CII- PricewaterhouseCoopers study on Indian Mutual Funds, "Opportunities and Challenges", which was released last week by M Damodaran at CII's Annual Mutual Funds Summit 2007 in Mumbai.

The Asset under Management (AUM) in the mutual fund industry has risen to of Rs.4.14 lakh crore as on May 31, 2007 recording a growth of nearly 50% as compared to the corresponding period in the year 2006.

Moreover, the proportion of AUM in tier one cities has come down to 88% in May 2007, from 90% in May 2006, indicating the growing importance of mutual funds in investment portfolio as well as changing preferences of the people in favour of mutual funds in tier two and tier three cities.

Despite a good growth, the Indian mutual fund industry has low penetration among retail investors and it needs to take lessons from mature markets like the US and UK where mutual fund route is used to meet the various requirements like planning for retirement, children's education and even to acquire assets. It forms a substantial part of the saving plans of the retail investors.

There is a need for mutual fund industry to widen the range of products to sustain the growth of mutual funds in the long run. Tapping the same urban retail investor wallet will not sustain growth and hence there is a growing recognition for tapping the semi-urban and rural markets, the study said.

In the present economic environment, when inflation rate is coming down and the interest rate is firming up, tapping rural market is likely to be a big challenge for mutual fund companies. They need to offer products, which are affordable as well as competitive against low risk assured returns of government sponsored saving schemes like as post office saving deposits. While rural markets offer a great opportunity for growth, product innovation would be a key challenge to tap this growth potential. "A classic example is the introduction of Systematic Investment Plans (SIP) by MFs with an investments as low as Rs 50 to Rs 100 a month", the study noted.

Further, the lack of appropriate technological infrastructure in rural areas represents a big challenge for the mutual fund industry and it needs to join hands with other sectors of the economy like banking and telecommunications.

An emerging area of growth opportunity for mutual funds is leveraging the development and high growth registered in commodity markets. "Commodity markets which are quite popular in mature markets may just be able to make a debut in India", the study noted.

Further, the mutual funds could also enable the small investors to participate in the real estate boom through real estate mutual funds. However, the study reported that a real estate fund would be with its own set of challenges and SEBI would be keen to ensure that all relevant regulations are in place to protect the interests of the small investors' confidence.

A major opportunity for Indian Mutual Funds would be to go global, the study noted. "Indian Investors are now allowed to invest up to USD 100,000 abroad. Fund managers having proven their mettle locally would be ready to take on further challenges. But the risks are manifold.

The retail investor ultimately has to be convinced about the opportunities available in the more mature global markets and the time is just right to make a beginning. With a strong regulatory framework, clear guidelines and the talent to back it up, the Indian mutual fund industry is in a position to cater to the new breed of investors who are keen to diversify their risks".

A major challenges before the MF industry would be the entry of new global players which is expected to go up further in the Indian Mutual Fund industry. It may lead to a new wave of consolidation by way of mergers and acquisitions (M&A) among the fund houses.

The report said that the smaller players of the MF industry may find it difficult to survive with the increasing challenges and growing competition. “With more and more new players keen on entering the market, a new wave of consolidation may spark of by way of mergers and acquisitions in the industry,” the report said.

The global players JP Morgan and AIG have started their asset management operations this year in India. The global fund houses are set to make their presence felt in India in a big way. Some of these fund houses are known globally for their specialization in structured products and offering an array of different choices to the investors, the report said.

Another challenge posed before the mutual funds industry would be that of dealing with the diminishing talent pool of the fund managers, pressures on margins, pressure of consolidation, innovation and product differentiation and meeting the issues of governance as an increasing responsibility is being placed on the Trustees to ensure that the operations of the funds are managed to the full benefit of the unit holders.