A recent study by SEBI has revealed increasingly speculative investor behaviour during IPOs. On average, investors sold 54 percent of IPO shares allocated to them within a week and 73 percent of the allotment within a year.
This clearly tells us that the key motivation of a majority IPO subscribers is listing gains, and as long the markets are vibrant such as today, this behaviour can continue. Only when subscribers start seeing losses over sustained periods would the frenzy behind listing gains reduce. That has happened in the past.
According to EY, in the first half of 2024, India witnessed a record number of companies coming the market via IPOs ~ 27 percent of global IPOs, accounting for more than 9 percent of worldwide IPO proceeds in the period. This trend is expected to continue in the second half of 2024 with certain large IPOs.
While the recent investor experience of investing in IPOs has been good, courtesy buoyant markets, that is not always the case. Most investors would have had a terrible experience investing in IPOs (of new-age internet companies) in 2022-23. Hence it is crucial to look at longer term historical data.
Data from global markets also paints a similar or worse picture. According to Professor Jay R. Ritter from the University of Florida, who studied US IPO trends from 1980-2022, three-year basis IPO returns are negative relative to the benchmark. While there could be many reasons for this pattern; two are very evident.
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- The seller, that is, the founder or PE (Private Equity) fund has a clear incentive to maximise their return through the sale process. Table 1 shows valuation (12-month Trailing P/E) of companies that were listed in the last five years.The bulk of them trade very expensive relative to the BSE Sensex valuation of 24.8 times (12M Trailing P/E). Valuations at the time of listing where even higher for a majority of them. Given the high valuations, there is limited room for further future price appreciation.
- We also find most of the IPOs happen either in the bull phase of the market or the best phase in the profit cycle for the firm. A case in point is the highest number of IPOs (~108) in 2007, after stellar returns from market in the 2004-07 period. To get a true picture of the company we need to take a normalised view of the profitability of the firm and ascertain management quality, which can only be gauged over a period of time after listing.
Quantum’s Founder Ajit Dayal likens the IPO to a beauty parade, where the investment banker who offers the company the highest price wins the mandate. Thus, interests of the investor is compromised. At Quantum we generally do not participate in IPOs. Apart from management quality which can only be gauged over time, liquidity consideration in the stock is also very important to us. Hence, we wait for the volumes to stabilise as trading volumes can be quite volatile in the initial period after listing.
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IPOs are a great vehicle for firms to raise money and fund credible business models. But investors must be extremely selective. While there can be some exceptional companies which may come through an IPO; historical data suggests (Table 1) that the odds are heavily stacked against investors making money in an IPO. It is better for the investor to wait, gauge management quality and let the newly listed company show normalised profits before ascertaining the fair value to be paid for the company.
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