The IPO season is back with a bang. First, the company behind the Cafe Coffee Day chain Coffee Day Enterprises will hit the markets today with its IPO to raise around Rs 1,150 crore or US$ 176 million. Then, later this month, India’s only profitable airline, Indigo, will open subscriptions to its Rs 2,500 crore or US$ 400 million IPO.

These are not anywhere close to the biggest of big IPOs India has seen, so rest assured that we are not at the peak of a bull market. 

But like all IPOs in the past, it’s very important for you as an investor to be careful and not give in to the hype and excitement that surrounds public issues. Towards this, here are my responses to the five key questions you may have about investing in IPOs. I also share below a template for analyzing an IPO document.

5 Questions on IPOs…Answered
1. What is an IPO?
IPO is the full form of Initial Public Offering, which means that this is the first time the underlying company is issuing its shares in public.

Some other definitions of this term, as defined by Benjamin Graham in his book The Intelligent Investor, include –

• It’s Probably Overpriced, or
• Imaginary Profits Only, or even
• Insiders’ Private Opportunity

Graham’s definitions are more appropriate, given the way IPOs have been in the past. They have created wealth for insiders (promoters etc), while profits for minority investors have been imaginary. And they have mostly been overpriced in relation to the underlying assets and profits of the businesses.

2. Why don’t IPOs make money for small investors?
Now that’s simple to answer – Because (most) IPOs are not created that way i.e., to let small investors make money. Yes, in good times when the investor sentiment is on the extremely positive side, you can expect to make some money on the listing day. But even that is mostly imaginary – as the IPO valuations already capture in the future growth and more of it. Plus, the entire thought of waiting for listing gains goes against the very grain of owning businesses for the long term.

3. Why are most IPOs overpriced?
People assume an IPO is an opportunity to “get in at lower prices”. In reality, by the time you buy shares of a company in its IPO, other parties have almost always invested earlier at lower prices – often, much lower prices. Before you even knew about the company, there probably were three or four rounds of private investment, and the per-share price of ownership usually goes up with each round.

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

They are not priced to offer you a piece of the business at cheap or reasonable prices, but to find “bigger fools” who can get in when the “privileged few” are getting out.

4. So why do most investment bankers and analysts recommend IPOs?
Don’t believe them! When an investment banker says an IPO is “cheap and attractive,” first know that his or her incentive lies in first fixing the IPO price (whatever the promoter wants) and then working backwards to justify the same.

It’s important to understand that the investment bankers and underwriters of IPO are simply salesmen. The whole IPO process is intentionally hyped up to get as much attention as possible. Since IPOs only happen once for each company, they are often presented as “once in a lifetime” opportunities for the promoters and other large shareholders to cash out.

Promoters and investment bankers thus create stories that are vivid – by using terms like “listing gains”, “bright future”, “long-term story” – and entice you to believe them as soon as you hear them. You must avoid getting charmed by that vividness. Try to go behind the beauty of that vividness, and scrutinize the IPO to see if it is really so bright and beautiful.

 

In other words, you need to get past the “bright and shiny” stuff that surrounds IPOs because it’s easy to fall into the trap given that so many others around you are falling for the same.

Don’t buy a stock only because it’s an IPO – do it because it’s a good investment.

5. Okay, how do I scrutinize an IPO i.e., do my own homework, before deciding whether to apply for an IPO or not for long term investment?
Here is an IPO analysis template I have created which you can use to analyze any IPO. I have used the case of the IPO that opens today – Coffee Day Enterprises (CCD). But this is not my analysis of CCD or a view on its IPO, but just a template on how you can study any IPO to decide why you should not apply to it. 

Click here to download the template (10 MB PDF) or read it in the panel below…

Final Word on IPOs
Here are some thoughts on IPOs from a few of the investing legends…

 

Warren Buffett wrote in his 1993 letter…

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

 

When Buffett issued Class-B shares of Berkshire, he made sure that it wasn’t a typical IPO. He wrote in his 1997 letter…

Our issuance of the B shares not only arrested the sale of the trusts, but provided a low-cost way for people to invest in Berkshire if they still wished to after hearing the warnings we issued. To blunt the enthusiasm that brokers normally have for pushing new issues—because that’s where the money is—we arranged for our offering to carry a commission of only 1½%, the lowest payoff that we have ever seen in common stock underwriting. Additionally, we made the amount of the offering open-ended, thereby repelling the typical IPO buyer who looks for a short-term price spurt arising from a combination of hype and scarcity.

The dot com crash of 2000 was preceded by hundreds of IPOs where the underlying business was literally nonexistent. In his 2001 letter, Buffett wrote…

The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.

Benjamin Graham wrote in The Intelligent Investor…

In every case, investors have burned themselves on IPOs, have stayed away for at least two years, but have always returned for another scalding. For as long as stock markets have existed, investors have gone through this manic-depressive cycle.

In America’s first great IPO boom back in 1825, a man was said to have been squeezed to death in the stampede of speculators trying to buy shares in the new Bank of Southwark. The wealthiest buyers hired thugs to punch their way to the front of the line. Sure enough, by 1829, stocks had lost roughly 25% of their value.

In Chapter 6 of his book, Graham wrote…

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 “favorable market conditions”—which means favorable for the seller and consequently less favorable for the buyer.

Charlie Munger said this in Berkshire’s 2004 meeting…

It is entirely possible that you could use our mental models to find good IPOs to buy. There are countless IPOs every year, and I’m sure that there are a few cinches that you could jump on. But the average person is going to get creamed. So if you’re talented, good luck.

To which Buffett added…

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.

Buffett also said…

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).

The late Mr. Parag Parikh wrote in his book, Value Investing and Behaviour Finance…

It’s safe to conclude that IPOs, which seem like a good investment vehicle are, in reality, not so. In fact an IPO is a product which is against investor interest, as it is mostly offered to investors when they are willing to pay a higher and outrageous valuation in boom times.

Prof. Sanjay Bakshi wrote this in a 2000 article …

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…IPOs are one of the surest way of losing money in the long run.

Four characteristics of the IPO market makes 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 a 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 an surge in the issuance of shares.

You get the message, right?

Hype and excitement doesn’t necessarily equate to a good investment opportunity. And IPOs are mostly about that – hype and excitement.

If we get back into a bull market and the IPO line lengthens, I’m afraid you’ll have plenty of opportunities to see that I’m right.