Will The Ipos In 2018 Be As Rewarding As The Ones In 2017? - Equitymaster

It has been raining initial public offerings (IPOs). The amount of funds raised through IPOs in 2017 is the highest in over a decade. With stock markets reaching new highs every day, companies are making a beeline to tap the primary markets.

In fact, if you are wondering want mood the markets are in, you just need to look at the number of public offers. 2017 has been all about crazy IPOs at crazier valuations.

Livemint says, Rs 570 billion has already been raised through IPOs so far this year, breaking the 2010 record of Rs 375 billion.

In such times, investors find it hard to overcome 'FOMO' - the fear of missing out. But rest assured - you are not missing out. Because an IPO is not always the best route to invest in a company.

Every IPO season separates another wave of investors from their hard-earned money.

At Equitymaster, we are quick to recommend an 'avoid' on IPOs, no matter how popular or big the name. Like we did with the IPO of Reliance Power in January 2008.

But, even we must admit, there have been some good IPOs out there. Famous IPOs like Infosys, Wipro, Maruti, and many more have made piles of money for investors smart enough to subscribe to their IPOs.

So should you snag a few for yourself? Not before you read this.

Of the 36 IPOs that we analysed in 2010, 22 are in losses today, averaging losses of over 60%.

This is despite markets touching lifetime highs.

In 2010 the Sensex was at a similar P/E as today, of around 24 times. But only 2 IPOs have offered annualized gains of over 15% - the standard long-term return that one expects of equity markets.

Investors, of course, have short memories and are still chasing them. If you ask me, this year's IPOs are going to suffer the same fate a few years from now.

And here is something I bet you didn't know about this year IPOs:

79% of the capital raised in 2017 is through offer for sale. All of it will go to owners or other shareholders of the business, offloading their stake either fully or partially.

This 79% is not getting invested in the business. It is headed straight into the pockets of the people who are dumping their own stake in the businesses, trying to get you to buy them.

So, us investors, with little information - a heavy prospectus, management claims, lead bankers' selling pitch and of course the herd mentality - are taking the bait.

The fear of missing out on listing gains, ie short term gains, is only taking the IPO mania to new heights.

If listing gains are what interest you, you should read what Ankit - the Insider at Equitymaster has to say.

How to Profit from IPO's in 2018?

That said, IPOs are exciting. There's no denying it.

A private business owner brings his company to the market. And he wants you on board!

You get to supply capital to the economy. If the company has issued fresh shares, then your money will be used to grow the business. In return, you get a share of the profits. Either dividends or capital gains or both. It is a win-win for both sides.

At least that's the theory.

Sadly, there's a huge difference between theory and practice. Many investors, as well as private business owners, do not think in this way. They don't care about mutual benefit.

First, let me talk about the sell side - i.e. the private business owners. These company insiders are advised by shrewd and knowledgeable investment bankers. These bankers are well aware of statements like the following from Warren Buffett:

It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).

In other words, their job is to tempt you to pay the highest possible price for the shares. At the same time, they must make you believe that the issue offers you huge upside potential. If you believe this, you are not acting in your best interest. You would do well to be aware of this.

Now, let me come to the buyers - i.e. the investors (retail, HNIs, and institutions). Most of the time, they don't bother to understand the business in any detail. In a bull market, like the one we are in now, they don't seem to care about business fundamentals at all.

What do they care about?

Two words: listing gains.

Yes, that's right. Even if the business is not a good one, even if the IPO is priced insanely, investors still flock to it hoping to make a quick buck. Some even borrow money to get a piece of the action.

The sad reality of the day is that the lure of quick profits has made a mockery of the entire IPO process.

But it doesn't have to be this way.

I would like to share with you two ways - the only two ways - investors should think about IPOs:

• The classical value-investing approach (suitable for most).
• The enterprising-investor approach (suitable for a few).

The classical value-investing approach to IPOs was made famous by the father of value investing himself, Benjamin Graham. It is a very simple approach: Don't invest in IPOs.

Why?

The owners may want to raise money for any number of reasons. They may want to expand their business. They may want money for personal investments. Or it could be something else. But whatever the reason, it is in their best interest to raise as much money as possible while offering as few shares as possible.

This guarantees that you will have to pay an overvalued price for the stock. If you do, and the company faces a problem after listing, the stock could crash. From Graham's point of view, this was too risky for the common man.

We agree. Graham was right. The IPO of Reliance Power in 2008 and SKS Microfinance in 2010 were the ultimate proof of how investors could lose their shirts even with the biggest and most talked about IPOs.

For most people, IPOs don't stand for Initial Public Offering, rather they should be 'It's Probably Overpriced' or 'Imaginary Profits Only' or 'Insiders' Private Opportunity'!

But there is another side to this story: the enterprising-investor approach.

As I mentioned above, this is probably not for most people. However, for some, it is possible.

These are usually experienced investors. They have already made a lot of money. They have seen the ups and downs of the market across various cycles. They have built up a solid portfolio of fundamentally strong stocks. They understand how the emotions of greed and fear move the markets. They don't care too much about listing gains.

In fact, such investors don't mind losing some money on listing day. On the other hand, if the bet pays off in the long term, the returns can be massive.So this means it is possible to make big money from IPOs...

But only with the right company.

At the right price.

Checklist of an IPO millionaire

In India, investors who skipped the initial offerings of stocks like Infosys, TCS, HDFC Bank, eClerx, Page Industries, etc over the past two decades may have regrets. But most did not pass on the IPOs over valuation concerns. More likely, they were either ignorant of the potential of these soon-to-be bluechips. Or they underestimated the companies' moat and growth prospects.

Buffett has explained that the mathematical probability of fetching a good stock at cheap valuations in its IPO is minimal. Therefore, investors hoping to become IPO millionaires have to rely on luck apart from their value investing skills.

To better their chances of becoming IPO millionaires, rather than relying on what the management has to say, investors need to follow a checklist. Keeping this checklist in mind might help you spot a rare IPO millionaire opportunity.

1. Companies in regulated sectors such as telecom or microfinance face few bottlenecks in the first few years of operation. But as the years go by, the regulatory supervision increases. Therefore, you need to be wary of the possibility of regulatory bottlenecks suppressing growth and margins in the long term.
2. Companies with extraordinary growth or profitability need to be evaluated on sustainability. If the profits are not coming from sustainable client or vendor relations, you would rather discount the same.
3. Meeting or judging the management of a company prior to listing is rarely a possibility. Therefore, the execution ability of the management is the last thing you may want to factor into the premium valuations you pay for the IPO.
4. It is not until the stock gets listed that you know the extent of transparency in its financial dealings. You can't judge the management's willingness to proactively explain challenges. Therefore, you would rather not buy a stock that would not have a business as simple as selling toothpaste.
5. Since most companies do not have a clear dividend policy prior to listing, all healthy cash flow generating entities may not have the best payouts. So while it is good to buy a cash-rich listed company, betting on rich dividends at the time of time of IPO may not work in your favour.
6. Finally and most importantly, the IPO is not your final chance to buy the stock. Rather, it is the first. Do not skip the valuation criteria in your IPO checklist. Value the stock as you would value any other long-term investment for your portfolio. Ignoring valuations could undo your chances of making money from even the best companies getting listed.

Therefore, investors can consider subscribing to an IPO if and only if the business offers adequate moat that is durable and sustainable in the long run and the valuations provide sufficient margin of safety.

You can check the top 10 companies having high Return on Networth (RONW) in the Stock Screener Module by clicking on 'Query on your own'. By selecting the industry and entering 'RONW', '>=', and '20' values in respective drop-down menus, you can run the query for the top 10 companies in an industry having RONW>=20.

The query also gives the 1 year forward RONW values on these companies.

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