Did you know that the more powerful and much faster tiger succeeds only in one out of every 10 deer hunts? In nine out of 10 times, the slower and much less powerful deer escapes. Why? The deer is running for its life whereas the tiger is only running for its dinner.
The much-awaited and talked-about event in the Indian stock markets lived up to its billing. The LIC IPO broke all records for retail investor participation with the retail segment getting oversubscribed 2.95 times, and a record 7.3 million applications being received.
The earlier record had stood for 14 years when the now much-maligned IPO of Reliance Power Ltd had received around 4.8 million applications.
I consciously stayed away from investing in the LIC IPO as I have done for all the IPOs for over a decade now. The possibility of listing gains has never made me rethink on my approach. The reasons:
Incentives
In 1995, investment guru Charlie Munger gave a speech on ‘The psychology of human misjudgement’ at Harvard, where he listed 24 possible causes of human misjudgements. The first among these and the one that immediately shook me is the human tendency to under-estimate “the power of incentives” to shape our behaviour.
Show me the incentive and I will show you the outcome - Charlie Munger.
Munger in that speech gave two examples -- of FedEx and Xerox -- to drive home the point.
In FedEx, the executives faced a curious problem of the night shift not turning over the dispatches fast enough from the warehouses. All attempts to speed up the shift failed until someone realised that the workers were paid by the hour.
They immediately changed the payment to a shift basis from the hourly basis formula. Instantly, and as if on cue, the shifts got over a lot faster with workers vying to get home early. In simple words, if you are paid for an entire shift, the incentive is to finish the job early. But if a worker gets paid on an hourly basis, he tends to work for as many hours as he can, thereby leading to unnecessary delays.
In the second example of Xerox, it was observed that a copier which was much inferior to Xerox was selling more pieces to the government. Upon analysing the problem, it was found that the incentives were structured in such a way that the salesmen received higher incentives to push inferior copiers over the better Xerox machines.
For me this was a Eureka moment.
I suddenly could see why people behave in a particular way. Whenever I must decide -- financial or otherwise -- I pause to reflect what is in it for the other party? I try to understand their incentives and objectives. Then decision-making becomes much easier.
Let us now look at the recent LIC IPO through this lens of incentives.
Incentives and IPO
So, what happens in an IPO?
The promoters, who are privy to all information related to the company, floats an IPO at a time of their choice through the book-building process with the help of one or a team of top-notch Book Running Lead Managers (BRLM).
The lead managers advice the promoters on the best time, issue size and issue price to help raise the maximum amount of money from the capital markets. Hence, it’s unlikely that the issue will be under-priced. The key parties involved in the IPO -- the promoters and the lead managers -- are incentivised to get the highest possible price and there are specific disincentives for getting a lower price.
In the case of LIC of India, the promoter is the Government of India, which acts through a separate department specifically carved out under the Finance Ministry called Department of Investment and Public Asset Management (DIPAM) to keep a laser-like focus on the equity investments of the central government with one of the key responsibilities being to meet the disinvestment target of the central government.
Lead managers are incentivised to set the highest possible issue price for subscription of the IPO, and the Finance Ministry and DIPAM are incentivised to meet the disinvestment target by getting maximum value as mentioned in their tender documents.
I have not even spelt out the incentives of the other parties involved in the IPO transaction -- underwriters, stockbrokers, depository participants, banks, and other financial institutions. Their objectives include increase in revenue (commission, brokerage), market share and profits. None of them have investor wealth creation or helping investors find a bargain as their objective. On the contrary, many of them are incentivised to do the exact opposite.
In such a scenario, for an individual investor it is more preferable and profitable to watch the IPO show from the sidelines, rather than actively participate in it. Yes, some listing gains may be lost, but it is always better to see the track record of the company for a few quarters or even a few years before parting with our hard-earned money.
Not just LIC IPO
Simply put, in our daily lives and investments, incentives matter a lot. It has great powers to distort human behaviour. Underestimating or ignoring the effects of incentives will lead to human misjudgement, which can be detrimental to our financial health.
Look again now through this lens of incentives and some of you will agree with me on why I gave the LIC IPO a miss. When the next hot IPO hits town, hopefully at least some of you will remember this view.
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