Why are mutual funds making a dash for investing in IPOs?

Not easy to find firms at good valuations

Fund managers say finding attractively-valued companies in IPOs during a bull market is not easy.

“In bull markets, companies coming with their IPOs are most likely seeking higher valuations,” says Krishna Sanghavi, chief investment officer-equities, Mahindra Manulife MF.

Says Vinay Paharia, chief investment officer at Union MF, “Right now, the IPO market is hot. It is difficult to find under-valued companies. However, very selectively, we try and look for companies that can grow and become large in future, companies that are innovative or research-oriented. But, we only invest when we feel that the company’s growth potential is not yet priced in the offer price.”

Paharia adds that his AMC follows an in-house quantitative model to arrive at a fair value for the company, by gauging its future cash flows, and then checking whether the price on offer is below or higher than its fair value.

He says that even in the recent wave of IPOs, his fund house decided to wait it out on certain companies.

Start-ups or traditional businesses?

The current euphoria in stock markets has not only prompted companies operating in traditional businesses to launch IPOs, even new-age start-ups are looking to raise capital from the markets.

For start-ups that are already profit-making, fund managers say they would prefer those businesses that can quickly reach a large scale.

“For example, between CarTrade and Nykaa, which are both profit-making start-ups, we would prefer the latter as we see more scope for growth in that business,” says a fund manager, requesting anonymity.

Adds Shridatta Bhandwaldar, head-equities, Canara Robeco Mutual Fund, “With profit-making businesses, you can stack the company’s current profits and future growth potential against its IPO price, to decide whether to invest or not.”
“As with any business, if the growth potential is good, one can be a bit more lenient with the valuations,” he added.

Dealing with start-ups yet to make profits

After success of Zomato, several start-ups have lined up their IPOs. Fund managers say with some of these start-ups, which are loss-making, traditional method of valuing businesses would not work.

“With the loss-making start-ups, we check whether there is a possibility of technology disruption and if the business can potentially access large pools of profits in the future,” says Bhandwaldar.

He adds, “However, when it comes to such businesses, we prefer to just have a small allocation in the portfolio so that we closely keep track of the business and can increase allocation if the business model is working. If it doesn’t, the impact on the overall portfolio is not much.”

Fund managers say that when it comes to betting on the IPOs of loss-making start-ups, the approach should be similar to that of venture capital funds.

“Venture capital and private equity funds spread their investments across a basket of 7-8 start-ups. There is a high mortality rate in start-ups; i.e., the share of companies going bust. So, diversifying such bets can help, but in an open-end mutual fund structure, the scope for doing that might be limited,” says Sanghavi.

According to Paharia, even if a company is makes losses, it is important to closely look at its balance-sheet, and figure out its operating leverage and revenue growth potential.

“Without understanding the impact of operating leverage, you will not understand how these companies can make substantial profits in the future, even if today they are loss-making,” he says.

A high operating leverage means the company has higher fixed costs than variable costs. This means the company’s operating income can see a more predictable and steady rise from revenue growth.