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Why you need to be careful while investing in IPOs

Investing in an IPO does look glamorous and is good to talk about. But it can be tricky if you don’t understand what the realities are

October 14, 2020 / 10:20 AM IST

Dev Ashish

Indian investors have a fascination for IPOs (initial public offerings) of shares. More often than not, people perceive IPO as a lottery ticket of sorts. And the ‘O’ in IPO is assumed to stand for ‘OMG’ (oh my God!) kind of returns. But generally, it ends up with an ‘Ouch’ of sorts!

But jokes apart, the primary markets are seeing some interest again now. A strong recovery in the secondary markets, coupled with improving sentiments, has enthused promoters to come out with their IPOs.

Investing in an IPO does look glamorous and is good to talk about. But it can be tricky if you don’t understand what the realities are.

IPOs are generally overpriced.

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It is in fact quite natural for promoters to do so if you think about it. Why?

Overpriced IPOs

Let’s say you own 100 per cent shares in a company you started a few years back. Now you plan to raise funds via an IPO. This means you will have to sell a small stake in the company. Right? Think about it now. Isn't it natural for you (the promoter-owner) to do everything in your capacity to get the highest possible rate for each and every share that you plan to sell via the IPO? And we can’t even call it greed. This is the way a normal person will operate. If you are selling your house, you would want to get the maximum possible price for it. Right? The same is the case with promoters selling their shares in IPOs too.

The promoter is selling his shares to new investors (i.e. people like you and me). He will set the issue price so that he gets the maximum possible amount from the stake sale. Most selling promoters tend to leave very little money on the table. As a result, the IPO investors will have to pay that ‘deliberately chosen high price to maximize gains for the promoter.’

These days, IPOs are less about pricing and more about marketing a story. And not just simple stories. You will be bombarded with fairy tales to build a hype around the IPO. Many will get excited and join the crowd. This is an old trick to attach stories to justify expensive valuations.

Rare superlative returns

No doubt, every now and then, some IPO or the other will give supernatural returns. Either on listing day and/or over a period of time. But these are far and few between. The norm is different if you check the data of the last several years. Most IPOs don’t make money for the investors. The stories being told at the time of the IPO can only remain true for some time. Eventually, business reality will catch up with the story and the price. And then, you already know how such stories end!

Remember that the promoters are selling shares and want to get as much money as they possibly can from you. Promoters are not here to do favours for you. So, your cost price automatically increases. And this in turn reduces your possible return in the long term.

And as I said earlier, IPOs tend to come more frequently when secondary markets have been rising for some time. Why? Because it helps create a perception that making money in markets is easy. In such an environment, anything and everything being sold will be bought easily. And hence, IPOs are timed to come in rising markets.

The lure of listing gains

Many invest in IPOs just for listing gains. But if the IPO is of a decent company, then given the hype-fuelled oversubscription, the allotment for retail investors is generally very small. So even if one gets an allocation, it won’t make much of a difference at the overall portfolio level of the investors. It won’t be a game-changer given the small allocation one gets in any case.

Having said that, who am I to stop anyone from investing in IPOs? But what I have written is the reality of IPOs. You can still invest in them if you wish. But do understand that in reality, it is just a hungry know-all promoter looking to get some money from common people who basically know nothing about the business.

If one is capable of investing in stocks directly, then it’s better to find stocks of good businesses available at reasonable valuations in the secondary market itself. For those who aren’t much into stocks, it’s best to have a financial plan in place and invest regularly via SIPs (systematic investment plans) in mutual funds, in line with their risk appetite and financial goals.

(The writer is the founder of StableInvestor.com)
first published: Oct 14, 2020 10:20 am

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