Should you invest in IPOs?

The markets were buoyant till recently and many companies waded in to raise equity through their Initial Public Offerings (IPOs). They believed it was a good time to capitalise on the positive market sentiments. Many of the IPOs were launched with high valuations, compared to listed peers. However, only a few companies listed in the past three to five years have managed to beat index returns. Many listed with a big bang and a premium but underperformed after that. While Somil recalls many high profile IPOs that have not recovered and continue to linger, his financial adviser thinks otherwise. With growth prospects showing a promising future in India, Somil wonders if it might just be time to consider investing in an IPO as well.Somil is right to be cautious. Skepticism is a positive attribute to cultivate in the IPO market. Asymmetry of information is the biggest risk in IPOs. The party selling the shares has more information about the company than the investor. Timing the IPOs is another important factor. Companies are tempted to often announce IPOs right after strong quarterly results. Investors like Somil must be careful not to extrapolate recent performance into perpetuity and pay a high price. Merchant bankers typically advise promoters to announce IPOs amid buoyant market conditions for it to be a success.Such companies are riskier compared to existing companies as in case of the listed companies, investors can look up their performance over several business cycles, allowing for better evaluation of growth potential and risk. The risk also arises from the life-cycle stage of these companies. Many of them are still young and not well established. Very little may be known about the promoters, quality of management and corporate governance. Having said that, not all IPOs must be avoided. Somil must do his own evaluation, study the IPO in detail and invest if he is convinced of its merit. It may be a dry read, but the prospectus lays out the company’s risks and opportunities, along with the proposed uses for the money raised by the IPO. For instance, if the money is being deployed to repay loans or buy the equity from founders or private investors, it may be worth giving the IPO a miss.However, funds going towards research, marketing or expanding into new markets paint a much better picture. He must check the company’s business model. Businesses with a competitive advantage that is hard to breach should be preferred. The financials must be strong and consistent. Hence, when a well-managed company with a leadership position comes out with an IPO for which no quality peers are available within the listed space, one may invest in it. Institutional presence, such as a strong PE investor, provides comfort on corporate governance. Most importantly, comparison of valuations with those of listed peers is critical for investment decisions. If a company can enjoy high growth for a sustained period, it is okay to pay a high price for it.Somil must go with quality, performance and transparency. If done cautiously, Somil could consider if he has a relatively higher risk appetite, a good understanding of the market trends and an ability to evaluate the company.(Content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.)

from Economic Times https://ift.tt/3x6Sb0o