Why are IPOs Overpriced & come in Rising Markets?

Now I already said this in a post few years back and I say it again: the very purpose of a company to do an IPO is to raise as much money as possible. They are not here to do any favors to anyone. They need money and want to have as much of it as possible.

For a moment, let’s digress from IPOs and assume that you want to sell your house or real estate. You will definitely try to get the maximum price for your house, isn’t it?

You are not concerned about the buyer at all.

Don’t feel bad about it – it’s natural.

Everyone wants to get more when they are selling.

But you don’t want to be at the receiving end of such a seller’s transaction. Isn’t it?

That’s common sense.

Why IPOs come in Rising Markets?

If you have been in markets for last few years, you would have observed that the number of IPOs increase, when markets are in an uptrend.

That is quite obvious as during bull markets, the perception of stock markets being a place of easy money becomes strong. This in turn helps IPO sellers to sell the IPO as dreams to potential investors. Investing in IPOs during bull markets can still be a profitable endeavour. But then again, IPOs during those time get hugely oversubscribed and allocation is pretty small. At times as low as being negligible, when considered in comparisons of overall equity portfolio.

Many people suffer from the Fear Of Missing Out (FOMO) syndrome, which pushes them towards IPOs. They put money in IPOs with the hope of making some quick gains and then boasting of high CAGRs. But for most people, hope is not a good strategy. If you are lucky, you might make money. But odds are stacked against common investors in IPO.

Older investors tell that the scene of IPOs has completely changed in India. Earlier, it was possible to make decent profits as issuers were not free to set IPO pricing – which was controlled and decided by the Controller of Capital Issues.

But now, its another ball game.

Though there is no strict IPO overpricing definition, fact is that majority of IPOs are not priced fairly – from IPO investor’s perspective. Or to put it simply, the scale of underpricing and overpricing of IPO, is skewed towards overpricing.

IPOs are built around hype and stories. And many are fairy tale stories. 😉 As the bull markets go higher, almost every story is able to excite the investors. Compelling stories allow expensive price tags to be attached to these IPOs.

But most of the (IPO) stories are not true – just like in real life. But problem is that these stories and hypes disrupt proper investing behavior.

Stories alone cannot keep the prices up. One day or the other, business does catch up with the price. Or rather, prices come down to levels of the real story behind the business. 🙂

And this is not something new.

Hype was that caused Tulip Mania in the 1600s. Remember Reliance Power’s IPO? The company was selling the hope that it will construct power plants and change the power sector forever. It was a one of the biggest IPO overpricing example in Indian history. Very few even bothered to have a look at NTPC, which was available way more cheaply and had actually set up large power plants!

It is amazing how people will not do simple things to make money!

Start early, invest regularly, do not interrupt the compounding process… but will continue to do stupid things.

In general, IPOs are only launched keeping in mind the interest of existing promoters and investment bankers. There is a reason why they tell you to read the offer document carefully before investing. 😉

If you are a long-term investor, you are better off looking for good stocks in already-listed stock space.

In fact, one of the big incentives for an IPO is so that previous investors – founders, venture capital firms, and large individual investors – can “cash out” at least a portion of what they’ve invested. That is why most IPOs are often expensively priced.

Now Warren Buffett has been quite vocal about his distaste for IPOs. This is what he had to say in a letter published in 1993:

…intelligent investor in common stocks will do better in the secondary market than he will do buying new issues… market is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of public…

11 years later (in 2004), he had some more wisdom to share about the IPOs:

An IPO is like a negotiated transaction – the seller chooses when to come public – and it’s unlikely to be a time that’s favorable to you. So, by scanning 100 IPOs, you’re way less likely to find anything interesting than scanning an average group of 100 stocks.

The seller of a $100,000 house in Omaha will never sell for $50,000. But if 100 entities each owned 1% of a basket of homes in Omaha, the price could be anywhere.”

At the end of the day, it comes down to the need for investors to understand – that IPOs are designed to benefit promoters more than investors. If they don’t understand this, they will eventually end up loosing money.

And as Late Parag Parikh said:

If consumers are irrational it makes sense for companies to cater to that belief rather than eradicate it.

Sounds logical to me. 🙂

Now its possible that going forward, markets might show signs of further revival. This in turn, would mean that companies would become ready to come out with their IPOs and FPOs.

The IPO sellers will start projecting these new companies as investments that can take you portfolio to the sky.

But remember, that the IPO sellers have the luxury of deciding the timing of the sale, i.e. they can choose to sell only when they get high prices for the shares. And that is what they will do.

Now for a moment, give it a thought. Why don’t IPOs come in Bear Markets? Or why does the number of IPOs hitting the market fall down when markets are not rising?

Mr. Parikh once said:

Companies don’t want to sell their shares in a bear market because they won’t be able to get a good price. But then where is the logic for investors to buy these shares in a bull market, when valuation is high?

I am sure that many people will still be interested in investing some money (say sin money) in IPO.

I am not stopping you.

Please go ahead and do it.

But just remember that you are buying shares from someone, who knows much more than you about what he is selling, has done everything (right and wrong) in last 1-2 years to make the financial statements look good, paid good money to merchant bankers to spread good words and stories about the company.

As IPOs in initial phase come out and start trading at significant premiums to their offer price, this gives a confidence boost to the next line of not-so-good companies, waiting to tap the market.

So the momentum continues to build up unless it stops. And as noted professor Aswath Damodaran says, the IPO game is a subset of the momentum game. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers.

So keep you eyes, ears and place where common-sense resides, open. 🙂

To be fair, there have been some good issues in the past and its possible that good companies might come up with an IPO that is worth investing. But identifying the ‘goodness’ of the company in itself is a very big task.

Most IPOs are not good for most investors – and hence, there is no reason for common investors to try and portray that they know the value of company better than the person who is selling his stake in the IPO.

Suggested Reading:

The Economics of IPO (and other) Markets (by Sanjay Bakshi)

You can read the full article here. Or can go through some IPO relevant extracts below:

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Any kind of rational comparison of long-term returns in the IPO market and the secondary market would show that investors do far better in the latter than in the former. Indeed many such comparisons have been done which cover data taken from several countries spanning over decades. The conclusions are always the same: that IPOs are one of the surest ways of losing money in the long run.

There are certain characteristics of the IPO market, which makes it unattractive for long-term investors.

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The IPO Market It is only to be expected that in a bull phase of the stock market, there will always be a sector, or a group of sectors, which are viewed extremely favourably by the investment community. These favourable views of the investment community are expressed by it in the form of high price/earnings, price/book value, price/sales and price/cash flow ratios commanded by the stocks of publicly owned and quoted companies.

At this time, privately-held companies in such sectors find that they possess an unlimited supply of extremely desirable “merchandise” i.e. their own shares.

Naturally, merchant bankers scramble to advice these companies on how to raise a large sum of money from the equity markets at inflated prices. (The recent development of book building for IPOs is nothing but an artful form of pitting one bidder against another in an attempt to create a high clearing price for the shares being offered).

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Four characteristics of the IPO market make it a market where it is far more profitable to be a seller than to be a buyer.

• First, in the IPO market, there are many buyers and only a handful of sellers.
• Second, the sellers, being insiders, always know more about the company whose shares are to be sold, than the buyers.
• Third, the sellers hold an extremely valuable option of deciding the timing of the sale. Naturally, they would choose to sell only when they get high prices for the shares.
• Finally, the quantity of shares being offered is flexible and can be “managed” by the merchant bankers to attain the optimum price from the sellers’ viewpoint. But, what is “optimum” from the sellers’ viewpoint is not the “optimum” from the buyers’ viewpoint.

This is an important point to note: Companies want to raise capital at the lowest possible cost, which from their viewpoint means issuance of shares at high prices.

That is why bull markets are always accompanied by a surge in the issuance of shares. It is true that often hot IPOs list at incredible premiums. The reason is simple: the demand for the shares being there, the merchant bankers ensure that only a limited supply is released to ensure a high price on listing.

Super profits are made by those who get shares allotted to them in the IPO, so long as they sell them at, or soon after, the initial listing.

This is where the trouble begins. Everyone wants a piece of the hot IPO cakes. Everyone thinks that he will get out at the top. Mathematically speaking, obviously this cannot be true. Moreover as time goes by, the investment quality of the issues tends to deteriorate.