IPO investing: Are the rewards worth the risks?

The hope of making a quick buck through an IPO is a compelling reason for several investors to participate. However, listing gains may or may not materialize the day a stock lists. Research analysts say investors should exit on listing day even if it leads to losses. “If an investor had entered the IPO with the sole intention of exiting with profits on the listing day, he or she should not stretch it if the listing disappoints. This is because several investors can look for exit after a poor listing, triggering a heavy sell-off,” says the research head at a broking house. Investors should also try and assess the long-term potential of the business.

Lemon Tree Hotels, which listed in April 2018 and had strong listing gains of 27.8 per cent (on a closing basis), is currently trading at its all-time low. Apollo Microsystems, which listed in January 2018 with a big-bang 65 per cent gains, is currently trading at 58 per cent below its issue price.

Understanding certain businesses can be tricky

There are chances of investors getting access to a new business in an IPO, which hitherto was not listed on the bourses. Such IPOs can offer robust gains due to the scarcity premium (i.e. lack of other listed players from the sector, leading to heightened investor interest). However, investors need to be careful that they don't get lured just by the novelty factor. Investors should make sure they do adequate research to understand the dynamics of the sector and potential risks it can face across different economic cycles. Such bets can come to haunt the investors if they have not fully understood different dynamics that can potentially disrupt the sector or the business. There can also be regulatory risks that might need to be factored in. This is why it is important investors read the red herring prospectus of the company, where such potential business risks are often outlined.

CAMS, which just concluded its IPO, is an example of a new business getting listed on the exchanges. The company, which operates as a registrar and transfer agents to the tightly-regulated mutual fund (MF) industry. In this case, though there aren’t any listed peers, you should analyse the fundamentals, financial prospects, relationship of the company with fund houses, revenue concentration, past or ongoing regulatory actions and so on before applying for the IPO.

Thoroughly understand company prospectus
Analysts say the red herring prospectus of a company can offer loads of information to retail investors about the business.

Gaurav Dua, head-capital market strategy and investments at Sharekhan BNP Paribas, says, “Investors should look for high double-digit return on equity and return on capital employed in the company’s disclosures. Secondly, the company should be cash flow positive, which can be gauged from the cash flow statement. Investors can also look at the leverage sitting in the balance-sheet, as well as earnings growth over the last four years.”

He adds that the prospectus can also throw light on the promoters or potential liabilities of the company.

Leveraged bets must be avoided

Broking houses offer loan facilities to investors who wish to take large bets on an IPO but may not have adequate funds. This is usually done by high net-worth investors (HNIs) who expect sharp listing gains and wish to make a quick exit post-listing. However, leveraged bets lead to higher break-even prices for such investors, as the interest amount also needs to be accounted for. If the stock price fails to exceed the break-even cost and starts falling after listing, it can lead to deep losses for such investors.

Are IPOs worth the risk?

IPO investing is a high-risk high-reward play, which may not be suitable for investors with a low appetite for volatility.

Alternatively, investors can always wait for some time, instead of participating in the IPO. They can look for signs that assure them of the quality of the management, corporate governance and business fundamentals before investing a bit later in the company.

It is worth noting that some among the most seasoned investors (Rakesh Jhunjhunwala, for example) have been highly cautious in the past when it comes to IPOs.