The psychology of IPO investing

I started my career in the capital markets in the year 2004. The bull phase had just begun in 2003 due to economic growth of the country improving and there was a subdued optimism when I began my journey.

The next few years saw the market picking up steam and reaching its peak in 2007 right before the subprime crisis ended the party in 2008. This period also saw a large number of Initial Public Offerings (IPOs) hit the market.

As the market crashed and remained lackluster, so did the IPO market. We witnessed a V-shaped recovery in 2010-2011 and yet again we saw the IPO market heating up. The next few years saw the stock markets in a bearish phase and this led to the IPO market drying up. As the Narendra Modi government came to power in 2014, we saw the market react positively and that started another bull run for the markets. This again coincided with a record number of IPOs hitting the markets in 2015-2016 and continuing till today.

Notice any pattern? I bet you do!                                                                                                                           

Let us try to understand the economics of an IPO.

A company intending to raise resources for expansion and acquisitions would like to go for an IPO. Or a group of initial investors desiring an exit would also opt for an IPO. When the company is selling shares to the public, it would want the maximum possible price for its original investors and risk takers. So most IPOs come out in a bull market when prices are high and irrational investors are willing to pay any price for owning stocks. The greed and overconfidence of investors are so strong during bull markets that they will be willing to buy anything at any price. Thus, promoters of the company prefer to dilute their stake when they are hopeful of getting a handsome price for their shares due to bullish market conditions. This further leads to some unscrupulous managements to come out with IPOs to cash in on the current IPO boom and take advantage of investor greed.

This is due to the fact that if investors have made money in a couple of IPOs then other IPOs (which are probably not of good quality) become representative of profitable IPOs. Investors blindly chase IPOs. This herd mentality creates huge demand and the IPOs tend to get oversubscribed. This demand- supply mismatch may create a profit for the investors on listing due to the prevalent market conditions. But as the listing euphoria dies down, so do the prices of many of these IPOs.

Today’s IPOs are offered at market prices. In the past, India had a Controller of Capital Issues (CCI) to decide the pricing of IPOs. This made subscriptions of IPOs very profitable and investors made handsome returns then. But today if you have to pay the market prices, then there is a huge choice for you. There are over 7000 stocks listed and available at market price. Then why would one want to invest in something that is already priced high? It is absurd to assume that IPOs are offered to the public at a bargain, as IPOs don’t come in bear markets. Also, for human beings, the penchant for chasing the new is so strong that investors do not see the reality and blindly chase IPOs.

Let’s take a look at an example of this behaviour.

Let’s go a little back in history during the technology boom in 1999-2000. Again a host of IPOs entered the market. All a company had to do was to affix ‘dotcom’ after its name to have investors willing to pay crazy valuations. We all know how this ended. Most of these IT companies have been delisted or have disappeared altogether resulting in massive losses to investors.

Another example is during the 2007-2008 real estate and infrastructure boom. A host of IPOs of these sectors hit the market to try and take advantage of the current conditions. Most of these have fared quite poorly since then. Let’s look at three of the big IPOs that hit the market during that time and their return as on January 31, 2017:

• Reliance Power: Down 91.84% from listing price
• DLF Ltd: Down 76.70% from listing price
• HDIL Ltd: Down 89% from listing price

(Source: Economic Times)

There are a host of other real estate and infrastructure companies that had the same fate as the above.

My basic argument is that, if one is lucky, one can come across a few IPOs where one can reap immense benefits. However, there are too many IPOs where one can get trapped and can lead to massive losses.

Be careful when you see a host of IPOs hitting the markets as they are looking to get the maximum price out of you. Investing is all about paying the right price for an investment, to reap long term healthy returns.

This post initially appeared in the India Markets Observer 2017 where you can read the perspectives and views of other experts too. It is available to all for FREE. All you need is a minute to register. 

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