Should you invest in IPOs?

Remember the 2004-2006 period, where not just DIYers but also amateurs, first-timers made money in the stock market IPOs. Well, those signs of temptation and overconfidence have not faded since. IPOs have been commonly perceived as get-quick rich options by retail investors. Even last year post the March crash, as the stock markets soared, a lot of IPOs fared well. Retail investors need to stay cautious though. Let us understand certain hard facts about an IPO first.

An IPO is an opportunity for a company to raise capital from the stock markets. Investment bankers help the company promoters in this objective by taking care of the regulatory issues, promoting the IPO and raise capital at the highest possible price/valuation. The irony here is that retail investors think that the IPO market is the primary window to get in at lower prices. But there are already privileged private investors who have invested earlier at lower prices in the company and are wishing to cash out. So, the IPO is not priced to offer a piece of equity to retail investors at reasonable valuations. IPO is just a well-marketed, well-hyped sale offer where the highest possible price is determined by the promoters. Even the timing matters. Most IPOs flock the markets when the market mood is good, i.e., in a bull market. Promoters hence get a greater chance of raising money at the desired high value. This is why most IPOs are expensively priced and retail investor are at the losing end.

Quoting an excerpt from the book ‘The Intelligent Investor’ written by Benjamin Graham:

“Our one recommendation is that all investors should be wary of new issues—which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues [IPO] have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under “favourable market conditions”—which means favourable for the seller and consequently less favourable for the buyer.”

Does this mean retail investors should not invest in IPOs? Is there an IPO strategy that a retail investor should have? The issue here is about having the right expectations from an IPO. If it is about chasing short-term listing gains, then it is important to understand that it is a matter of pure luck. The share price may list at a premium to the offer price or at a discount. So, if a retail investor wishes to earn quick money in an IPO, i.e., if he is interested only in listing gains, he should be prepared to lose money just as quickly. If a retail investor wishes to invest for a long term, he will be better off buying from the secondary market. Even in this case, the investor needs to evaluate the company first on the basis of merit and not hype.

Remember, hype and excitement do not necessarily tantamount to a good investment opportunity. Before jumping onto the IPO bandwagon, set your expectations first.



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