Why invest in an IPO: Experts explain

Consider this, in 2009 the market saw almost Rs 50,000 crore raised from the primary market. In the year after that, that number actually doubled. But this year, the market has seen a paltry Rs 8000-9000 raised from the market. Many of them have been issues that are so small that often it is difficult to understand what the business are about and how exactly these companies should be valued.

CNBC-TV18�s special show Informed Investor, talks in more detail about the primary markets space and how to approach the potential initial public offerings (IPOs). It discusses which one is worth a subscription and which one looks like a skip. S Ramesh is the COO of Kotak Investment Banking and Prithvi Haldea, CMD of Prime Database explains why investment in an IPO gives better returns and how to look at it? Here is a verbatim transcript of their comments. Also watch the accompanying videos. Q: Let me start with the first basic question that any investor should ask themselves. Why invest in an IPO or an initial public offering? Haldea: There are two reasons. One is that to pick a stock from the secondary market can be a very difficult exercise. So, you may have to study a large, couple of 100 or 1000 of companies to pick up a stock or depend upon an advisor who can or somebody giving a tip. Therefore the whole business for a first time investor becomes very difficult buying from the secondary market. IPOs historically are good entry point. Whatever maybe the post listing performance, you pick up IPOs of a particular period and then say that so many are quoting below or above the offer price. But historically we have found that the IPOs tend to get under priced. Therefore there is an opportunity for an investor to make some money in the IPO route and there is also much more focus on an IPO. There is much more analysis which is being done when an IPO comes in the margin rket unlike secondary stock which are in 100s. So with all that focus and the historical comfort of under pricing makes IPOs attractive for small investors. Q: One qualitative take from you on why the drop in interests has happened? Is it just to do with market performance or has something become more flawed in the primary market space? I mean you can almost break it up into the pre Reliance Power and the post Reliance Power era, something has changed in the dynamics of that market? Haldea: One very basic fundamental change which has come is that real-estate or infrastructure as a whole which was considered to be the booming sector where lots of money was raised by the companies through the IPO route and FPO route. There was substantial disappointment both from Reliance power and a huge disappointment also with the real-estate companies, scores of which has entered the market. And there have been big question marks about their valuation methods, transparency, corporate governance and therefore the sector which is actually requires the maximum amount of money is the infrastructure sector. This has been almost lying dormant in the primary market for the last two years post 2008 crash. And unless this sector comes alive in the market we will have very small IPOs coming in because that is where most of the money is currently required or divestment. These are the two areas where I can clearly see lots of money being raised or required. You are right that Reliance Power was the beginning of the power sector attractiveness to the primary market investor. Q: Coming on the point about pricing because that�s where the merchant bankers face the most criticism. The fact that very often pricing is not in sync with the company�s fundamentals and in fact instead of offering a little more on the table there is more take off the table for a retail investor? Ramesh: I would beg to disagree that pricing of IPOs is not based on fundamentals. So let me state how we look at pricing conceptually. There are 2-3 important things that we keep in mind as we look at pricing. One is the fundamentals of the company which also includes our own perception of the track record of the promoters and their ability. Some of it is subjective and some is quantitative. Second is the state of the secondary market � how is the market doing, is the wind a little positive, is it more volatile, is it likely to be negative. And third is, since most of the IPOs now are done on hook built basis we also keep in mind what has been the investor sentiment and investment feedback and what sectors the IPO is from. So combination of these 33 parameters is what leads us to pricing. Also typically IPOs always are at a discounted rate because they are listed for the first time. The thing is that the share price of a new company which gets listed also adjusts itself to the company performance. _PAGEBREAK_ Q: Divestment has looked like the most exciting space in the primary market universe. There is ONGC and SAIL, those kinds of large sized issues coming up. How would you line up the landscape from the divestment side and what would you say are the most interesting issues to watch out for through the course of FY12? Ramesh: I would refrain from commenting about specific issues. But I have been personally a great champion over the years about government companies. I think they are large, profitable, great companies with track record. Typically they are monopoly or duopoly players and the fundamentals of such businesses have always attracted both institutional and retail investors. Right from the time the first Maruti divestment happened several years back to as late as a few months back we have always seen this consistent trend. And my own view is that given the strong fundamentals we are seeing especially from a retail investor point that generally they have made returns. I would just give guidance to retail investors that there is reasonable opportunity to look for in this coming fiscal year on the divestment front as Rs 30,000-40,000 crore of IPOs and FPOs are lined up. So I think they should really look at studying the fundamentals and looking at investing in these government companies. I think the past track records have shown that returns have been made. Q: The basic question is how do you value some of these issues and the first premise that comes forth is peer comparison. Is that the best way to go about it to see what one infrastructure is doing versus the other in terms of its revenue, sales, profits, debt levels and then decide whether or not it looks like a good buy? Haldea: I believe peer comparisons can only be a starting point. It can be a indication because no two companies are alike, no two promoters are alike and therefore to either look at a PE ratio or similar PE ratios or similar profit numbers or revenue numbers I think are not going to really serve the purpose. However that is the benchmark which is typically used in terms of pricing an IPO but we know that in every sector whether its real estate or IT or anywhere you will find companies who are enjoying PE ratios from 1 to 100 and then you have an average. This average is also meaningless and then you have this whole spectrum of 1 to 100. So how do you really place a company unless you start comparing every single factor and then you will find that these are not comparable. Valuation is a very difficult game. As far as retail investor is concerned I advice them not to get into understanding the valuation and pricing. They should basically depend upon the qualified institutional buyer (QIB) response because they are intelligent. The whole idea of bringing in compulsory QIB participation 10 years ago was basically because retail was not able to take a call on pricing and therefore you have a system where half the book is reserved for institutional investors. They should typically use the cut off and look at the QIB response. One more factor that I advice lot of people to look at is to see whether there has been a PE or VC investment in that company prior to the IPO and whether those funds are continuing to remain invested post issue. Are they existing fully or partly through the issue or are they going to remain invested. Q: There is one other method of caging these IPOs which was the rating method introduced a couple of years back where a certain grade was attached to an IPO. That hasn�t quite worked because the company could get a 3 on 5 or a 4 on 5 even which meant it had great fundamentals but performance was still lacking and there were still question marks either about the promoter or about the business? Ramesh: My understanding is that the rating agencies as they look at rating an IPO, they look at all these factors- business, sector, promoters, track record and what they attribute as risk and the financial study of the company but what they may not be taking into account is the pricing of the IPO. So, if I were to look at rating from a retail investor point of view, I would look at it in two ways one is if IPO company gets a really poor rating which could be one of two it�s a great red flag. It atleast tells the investor that look the rating is 2 atleast do more homework before you invest. Similarly when the rating is a high rating 4 or 5 it gives comfort to the retail investor that from a fundamental point of view a professional agency has felt comfortable giving this rating and I think the retail investor should not just be satisfied with this.  He must talk to his advisor or sub-broker or broker about what their views on the pricing are. A combination of these two exercises will probably enable him to take a more intelligent decision. _PAGEBREAK_ Q: Most successful IPO performances in the recent past have been Jubilant FoodWorks and Talwalkar�s, both have no peer in the market as such, both have been privately held. They hit the market and both were actually seen as on the expensive side when they stepped into the market. How do you go about valuing or gauging these kind of stories where there could exponentially be great returns, but at this point it�s difficult to take that call? Haldea: They can also give you huge losses, so new sector IPO do not necessarily mean that they will give you exponential returns. They can also be dead ducks. But as I mentioned earlier peer group comparison is only a starting point because every company is unique, every business is unique. In cases when you do not have a peer comparison, the job is almost as similar as when you have peer group comparison because peer group comparisons sometimes can lead you to take very wrong decisions because as I said companies are not alike. We have seen a new sector also not doing well, the first time entrance, I would again depend substantially upon how a QIBs understood that business? What kind of response are they giving to the issue? Q: The government has traditionally worked with FPOs in terms of raising cash or hitting the target, but inarguably, the most successful performance has been from Coal India,. What was so right about it? And could that be a space to look at? New issues that come in from the government stories that have henceforth or have not in the past been part of the market or represented in the market? Haldea: Clearly, as I mentioned again earlier, IPOs from the PSU sector will always present a very attractive investment opportunity for investors. Most of these companies are very large with huge track records. There is no way you can decide what is a fair price because these are all hindsight advantages that we tend to get. We have seen that PSUs typically tend to be more moderate in pricing and therefore give very good returns. So my advice would be always to look at IPOs very closely and invest in them. FPOs unfortunately, that is where the focus of the government is right now, looking at existing companies like SAIL, PFC, which just happened or IOC or lot of other companies and disinvestment through the FPOs. The present system of FPO should actually be abolished. My recommendation is that we should do a close book to institutional investors, let them discover the price and bid at the price that they want to bid at. After you have done the allotment to QIBs then you take the average of that price, one of the lowest of the QIB price and then do a retail offering, that would be a more saner(check) method of selling FPOs are they competition with their own price on a daily basis. Thirdly what I look as a small investor, I would also look at the price movement of that company for the last say 3 months or say 6 months. Q:You want to comment on that point about FPOs because that�s where the big mismatch is and that is the criticism. The movement the market gets to know there is an issue, where there is a FPO coming, the price begins to fall in the cash market and the value for the current holder, the current investor in that stock actually depreciates, any way of coming around this entire FPO tangle? Ramesh: See my view on this has been that most of the FPOs barring one or two private sector exceptions have come form the divestment�s table. So fundamentally many of these companies are good strong companies. Some of the private sector companies, which have done FPOs are also very strong and large companies. So first generally what my view is that FPOs have come from companies with good track record, so investor should look at this opportunity seriously. Second is what retail investors must keep in mind is that investing in an FPO is like catching a running train or a running bus because there is a stock price, which is constantly changing and they have to sort of look at this as they take their investment decisions. From that point of view, most divestment issues, almost all of them have kept that standard mandatory extra discount for retail, which I think is a good bet and as long as there is reasonable gap of another 3-4% between the FPO price and the stock price prevailing on the day of the opening of the issue. In addition, combining that with the additional discount upto 5% that retail investors typically get. Most of the FPOs retail investors should look at investing pretty seriously. Q: This year has not been special to say the least for IPOs. A stock lists at a 50% premium, the next day its down 20% the day after that down another 20%. What have you made of that? You talked about QIBs but that as well seems to be a very closely held allotment. It almost seems to be tacit understanding of selling immediately after listing. How do retail investors keep away from those kind of stories? Haldea: You have really analyzed that well and I would suggest in the current market circumstances that retail investor should typically keep away from IPOs which are Rs 100 crore or less. You are almost taking a position of a venture capitalist in these companies. There is hardly any public validation, QIBs could be managed and therefore there is no need for a small investor to go behind such issues because they are more vulnerable to rigging not just by the promoters of QIBs but by also operators and brokers. Therefore you could be left high and dry when you go into these kind of IPOs. Whenever I find that a promoter or a company has been involved in too much litigation, too many cases filed against it, too many enquiries going on against it. That typically presents a mind set of the promoter and therefore I would typically keep away whatever be the compelling reasons to invest unless I am a trader. Third is that I would also look at in these cases the number of QIBs who are participating. Q: You want to add to the red flags that Prithvi raised for instance the kind debt a company may have? What kind of previous financial performance track record they may have or even the kind of promoter holding that some of these issues come to the market with? Ramesh: Before I go into that, I would just like to mention to the retail investors specifically that in their mind first and foremost and this is in bold capital letters that any equity investment has risks and they must not approach an IPO or an FPO with typically getting some gains or the other on IPO listing. I think the current capital markets are volatile. They are changing due to internal and external factors for India. Therefore when an investor decides to come into an IPO the first suggestion I would give him is, in his mind to select between investing in an IPO and investing in a company which is doing an IPO. Sometimes when market conditions are bullish, little good, what happens is the IPO, first day listing or the first week listing gains tend to be good, so investors can be a little opportunistic but they have to be little careful. The second part is that a strong fundamental company which comes to the IPO market, the timing of when they come is not necessarily in their control because sometimes the timing of the external markets could be good or not so good but they must draw the comfort that the company they are investing in is a strong company with good fundamentals. Even in the short term it doesn�t give them appreciation or gains, they are pretty safe staying invested in that company. So this is the first distinction an investor should make. Second I would suggest for retail investors consideration is promoters and the track record of promoters is something they must pay attention to. Is it a first generation? Does he have a track record? Has he brought companies to the market? This will give them some cue about what is the track record of the promoter second is to which sector does the IPO belong? Is it a sector that is growing or not growing at the current movement?