Why retail investors must avoid IPOs despite the market hype

This is not a lone story. Many other IPOs such as those of Gammon Infra, DLF, Shriram EPC and Jaypee Infratech have met the same fate.

In fact, statistics show that out of the 207 IPOs in the last 10 years, only 21.26 percent were multi-baggers, yielding over 100 percent returns. Only 7.73 percent yielded over 50 percent returns. On the contrary, a whopping 45.89 percent yielded negative returns. It is precisely for this reason that value investors usually avoid investing in IPOs, as they are no less than a gamble.

Reflecting the same sentiment, Warren Buffet said at Berkshire Hathaway’s 2016 annual shareholder meeting in Omaha, Nebraska, "You don’t have to really worry about what’s really going on in IPOs. People win lotteries every day but there's no reason to let that affect your investing strategy at all".

Before you read further, it is important to understand what an IPO (Initial Public Offering) is.

Here are six reasons why retail investors should avoid IPOs.

Hype can lure you into an emotional trap

Most people who indulge in stock trading tend to get swept away with emotion easily, especially when they are lured with the prospect of transforming their lifestyle overnight. However, looking at past data on the performance of IPOs, one can clearly say that the buzz around IPOs is more of a hype and has little to do with the value they offer in reality.

Even the underwriters and investment bankers associated with an IPO are no less than salesmen in the process and have a huge role to play in creating a vivid narrative to lure investors. In fact, since IPOs only happen once for any company, they offer the promoters and large shareholders the perfect opportunity to cash out at a high valuation. Hence, they have more to do with the promoters' interests than the investors'.

Exorbitant pricing    

The common perception amongst investors is that IPOs are an opportunity to make their way into the company at lower prices. However, even before you have invested, the company would have undergone several rounds of private investment. Remember that the price of the shares only goes up with each round of investment.

Moreover, in the secondary market, the demand and supply of the stock determines its price. But an IPO is more like a one-sided game where the company together with its investment bankers decides the issue price of the IPO, which is almost always at a premium.

IPOs are usually launched in bull markets

The fact that most IPOs are launched in a bullish market defies the basic principle of investing in the stock market since the investors are exposed to maximum risk at this point.

A surge in demand in a bull market could lead to the shares getting oversubscribed and their prices getting inflated, thus leading to good returns at the time of listing. However, once the market turns bearish, the stock prices crash, leaving the investors in a fix. HDIL and DLF were two such IPOs that left investors in the doldrums.

Most IPOs underperform in the long run

As is the case with bull markets, most investors only hop onto the IPO bandwagon with the hope of making listing gains or short term gains. Sticking around for the long term is not a great idea either since most IPOs tend to lag behind in the market simply for the reason that they start off with a high valuation in the first place and then fail to live up to that hype.

As a result, in case of many IPOs like Reliance Power, the share price has never really gotten anywhere close to the issue price even after all these years.

Lack of sustainable business model

Many new age tech start-ups getting listed nowadays don't yet have a proven business model that can sustain the business in the long run. They see IPOs purely as a means to raise funds and keep the business going to meet their next milestone, and therefore, don't make for a wise investment.

It comes as no surprise then that even IPOs of supposedly well-known tech driven start-ups like Easytrip failed to make a mark in recent times. Even globally, established start-ups like Uber and Lyft ended up a damp squib, with Uber registering the worst ever Day 1 loss in the US IPO industry.

The odds of losing money are high

Statistics for the period 2011-2020 have proved that the odds of winning to losing in IPOs are 40:60. It is best to base your investments on hard facts and numbers than your stock broker's advice since they are likely to recommend what earns them the best commissions and not necessarily what's best for you.

Conclusion

As much as investors wait for the next IPO in anticipation of multiplying their wealth quickly, the fact remains that only a small percentage of these IPOs yield lucrative returns. On the contrary, the odds of losing money are much higher. Retail investors must therefore exercise complete caution and do thorough due diligence from their end lest they end up losing their hard earned money and are left in a lurch.

Instead, the focus should be on building a quality portfolio consisting of 10-15 simple, predictable and dominant businesses with strong balance sheets, free cash flow generation as well as clean and efficient management. This is the key to consistently generate secure, inflation-adjusted, risk-adjusted, and tax-efficient returns in the long run.