Why IPOs are no longer alluring

Going by 2004 when initial public offerings bloomed, 2005 was expected to be another bumper year for IPOs. It did look like boom time for everyone involved - sellers, marketers and buyers.

But then came the rotten eggs. And in the mad rush to get onto the profit wagon, investors tasted the bitter pill.

While it is true that the bull market of the past year-and-a-half has been helped along by several quality issues -- both primary and secondary -- the trend in the immediate past tells a different story.

Several inconsistent and even loss-making companies approached the market to raise money in the recent past. And they got the price they commanded. Sadly, investors haven't got the price they expected post-listing.

Sample this: Punjab National Bank is quoting (Rs 384.60) below its issue price (Rs 390). So is Jai Prakash Hydro Power (Rs 27.75 against Rs 32). Shringar Cinema is trading pretty much at its issue price of Rs 53.

PNB's lowest price since the issue is Rs 337.50, while Jai Prakash Hydro's current market price is the lowest and Shringar hit Rs 43.10 after its listing. But for the run up in the last few trading sessions when the market rallied, another three-four companies would have been in the red post-listing.

Clearly, IPOs no longer seem to be the less risky option they are often touted to be.

"Retail investors are still considering IPOs as an easy means to make money and the sellers are cashing in on the opportunity" says Ramesh Damani, a well-known broker and market participant.

Investors have to exercise caution while investing in IPOs, to say the least, in order to emerge unhurt.

The demand is high...

As the law of demand goes, the price is high when the demand is high. This year, all issues that hit the market got oversubscribed, with scant respect for pricing.

On an average, issues were oversubscribed by over 25 times where the qualified institutional bidders' portion was oversubscribed 26 times, non-QIBs' portion about 65 times and the retail portion around 28 times.

Active participation of FIIs in these issues has been cited as the reason for this over-subscription. To get a clearer picture, around 70 per cent of QIB allotments were given to FIIs.

Diminishing returns elsewhere in the globe meant that FIIs - flush with funds - picked up domestic stocks left, right and centre.

As their exposure to several front-line stocks were at record levels, FIIs have been more than enthusiastic about primary offerings.

Domestic funds, too, have not been sitting idle. The need to boost the asset base and returns had seen them launching any number of new funds during the year {mutual fund flows in to equities - year-to-date - amount to Rs 6,070.99 crore Rs 60.71 billion)}.

Again, the excess funds in hands of desi funds meant that they had to be deployed somewhere and fast. Naturally, IPOs seemed to be the ideal space to park these funds. Also, the lure of quick listing gains made IPOs the best bet for even the not-so-savvy retail investors.

...so the price is high

Promoters obviously want the most money for their issues and rising markets are the right time to raise it. With big institutional buyers willing to pay a premium over and above what may be the 'ideal price', the primary market became a sellers' market.

The fact is that pricing of an issue is based not just on the company's fundamentals but also on the market sentiment at the time of issue. A booming market would invariably attract a higher valuation since the peers, too, quote at higher prices.

"The IPO market has largely become a sentiment game," says Parag Parikh, chairman, Parag Parikh Financial Advisory Services. "Pricing tends to be higher if the mood in the market is buoyant," adds Dr Subramanian of Enam Financial Consultants.

The moot point is that investors end up paying an additional premium not just for the company's expected future growth but because of the market condition as well. So it is not as though there is any additional margin of safety in primary issues.

A look at all the issues during 2005 gives us a sense of the growing mismatch between quality and pricing.

For instance, the valuations that many recent issues were offered at the time of issues were unduly high, for no justifiable reason.

For example, Allsec Technologies quoted at an issue P/E of over 19 times (based on annualised earnings) which is what its peer Datamatics quotes at one-year forward earnings. The same holds for Shringar Cinema, which was making losses and commanded an EV/EBITDA of about 50, which seems absurd for an exhibition business.

Jaiprakash Hydro, too, issued at a P/E of 12.8 - same as that of some of the biggest and oldest power generation companies. Essentially, investors are paying the same value for a company which is yet to prove its mettle or they exude tremendous faith in a yet to be set up business.

However, there are some exceptions -- Jet Airways, Bharati Shipyard and Gateway Distriparks. Not that these issues were any cheaper, but they had a strong reason to command a premium. Call it the rarity premium.

Jet Airways is the first operational airline stock to get listed and given the kind of growth envisaged for the sector, it was bound to experience stupendous response. So the issue got oversubscribed 14 times though the issue price was slightly on the higher end of Rs 1,100 at an earnings multiple of 25.

Bharati Shipyard is the first ship-building company and Gateway Distriparks is the first logistics company to debut at the bourses. Their issues got oversubscribed 77.8 times and 28.7 times respectively.

Manipulation?

Apart from the blatant overpricing of issues, there is an ever more disturbing trend. Primary offerings by already listed companies (for instance, Emami, PNB, Allahabad Bank, Oriental Bank of Commerce and IVRCL Infrastructures and Projects) are often prone to high level of speculation; some could easily pass as manipulation.

In most cases, the stock price shot up sharply before the announcement of the price-band only to make the issue price look cheap compared to the prevailing market price. So post-issue, the stock is ripe for a de-rating.

"The pre-issue rally is often the handy-work of merchant bankers who want the best price for the companies they handle," says Parikh.

For instance, PNB's stock ran up 19 per cent in a month to the day the issue price was announced while Allahabad Bank's price was up 21.5 per cent. After the issue prices were announced, the stocks of PNB and Allahabad Bank fell 23 per cent and 13 per cent respectively.

In fact, one would have been better off purchasing these shares a month ahead of their issue. It is another matter though, that the short-term blips in banking stocks may be ignored in view of their long-term growth potential. The same logic, however, may not apply to all stocks.

A losing game

Despite efforts by the securities regulator to increase allocation to retail participants, the odds seem to be stacked against common investors as far as primary markets are concerned.

For one, common investors have little say over pricing. Investment bankers typically decide on the issue price-band after a pre-marketing session with institutions. The band is determined based on how much institutions are willing to pay.

"Ninety-nine per cent retail participants still come in at the cut-off price," says Subramanian. Which means they do not have any say in the issue pricing anyway.

Secondly, considering the fact that retail investors have to commit funds upfront while applying unlike institutional investors who are allowed to make bids at the time of the issue and pay later as per allotment, the game seems to favour big players.

But most importantly, it's the twin danger of over-pricing combined with market sentiment risk that makes the IPO game more risky than it seems.

What should be your IPO strategy?

A look at what kind of IPOS have given investors value for their money should be a pointer as to how to go about choosing your primary stocks. Stocks from fresh sectors are the ones that still hold up their ground.

To cite some examples, Bharati Shipyard is up 154 per cent and Gateway Distriparks is up 112 per cent as compared to their issue price.

Some others like IVRCL (up 24 per cent), Allsec Technologies (up 23 per cent), 3i Infotech (up 1 per cent) and Allahabad Bank (up 3.8 per cent) made a bad start (with their prices tumbling post-issue) and recovered only after the market sentiment turned bullish.

"It is not fair to generalise that IPOs are bad," says Abhay Aima, country head (equities and private banking group) of HDFC Bank. All said and done, investment in an IPO should be viewed on a case-to-case basis.

Take for instance, banking stocks, which are still a good story. So momentary blips in their prices are pardonable. Here are three rules you must follow while considering an IPO:

• IPOs should be treated as secondary market purchases. So always compare the valuation for the issue with that of its listed peers. In the case of relatively new sectors, take a cue from international companies. Subscribe to an issue only if it is at a 15-20 per cent discount to peer group.
• Never go for listing gains blindly. If the market sentiment turns sour between the time of the issue and its listing, the listing price may not be as per expectations.
• Always look for long-term growth stories and sector outlook. Even if they are subject to the vagaries of the market, you will realise handsome gains over a period of time. Imagine, buying HLL or Infosys during their IPOs.