Checklist of an IPO Millionaire

Oct 28, 2015

In this issue:
» The root cause of the malaise afflicting SEBs
» Why India Inc needs to pull up its socks quickly...
» Market round-up
» ...and more!

Warren Buffett is often heard expressing his unwillingness to invest in IPOs.

The billionaire passed on the opportunity to subscribe to Google's IPO in 2004, which was offered at over 52 times earnings. In addition to Buffett's general reluctance towards the business models of most internet companies, Google's early valuations clearly didn't interested him.

The stock returned nearly 1400% in ten years, proving Buffett's intrinsic value calculations wrong. But he didn't compromise on his margin of safety criteria, and the legendry investor never regretted his decision.

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.

But the fact is that, like Google, each of these companies have offered post IPO investors plenty of opportunities to join their wealth creating journey...the opportunity to become millionaires.

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 very little 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 that 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 the chances of making money from even the best companies getting listed.

Like the current IPO of Interglobe Aviation, some very interesting businesses with compelling propositions will seek to get listed in the coming months. With this checklist and a long-term wealth creation goal in mind, your investment in their offerings could give you the opportunity to become an IPO millionaire.

What are the criteria that you have in mind while investing in IPOs? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
State Electricity Boards (SEBs) are in a dismal financial health with huge losses accumulated over the years. In FY14, the state electricity utilities had a negative networth of Rs 1.06 trillion (Source Power Finance Corporation Report). And the major reason for the colossal loss is that the SEBs sell power at a price much lower than their actual cost. In FY14 this deficit differential stood as high as Rs 1.15 per unit.

Power theft and technical losses in distribution due to poor infrastructure have led to lower recovery by SEBs. The distorted tariff structure across consumer categories has further compounded their problem of poor realizations. The agricultural consumers paid only Rs 1.83 per unit of electricity as compared to actual cost of Rs 5.15 per unit in FY14. This is on account of huge subsidies being offered by state governments to build their vote banks.

On the other hand, large industrial and commercial users in many states such as Haryana, Andhra Pradesh, Uttar Pradesh and Maharashtra end up paying much higher tariff as compared to agricultural consumers. This is driving away the largest and strong customers of SEBs who are setting up their own captive generation plants. As a result, the cash flows of the indebted SEBs are getting constrained further thereby curtailing their ability to upgrade infrastructure.

Thus SEBs are caught in a vicious cycle. They have piled on large amounts of bank borrowings that they are unable to service on account of continued losses. As a result the financial soundness of banks particularly state-owned has come under strain. In a bid to resolve the logjam, the government is contemplating to restructure the debt of the SEBs by allowing them to be taken over by the respective State Governments. The State Government would in turn be issuing bonds that would be subscribed by banks and financial institutions. However, we believe that instead of such short term solutions, the government should focus on rectifying the anomaly in the tariff structure to ensure long term viability and profitability of SEBs.

Industrial consumers pay the price of government largesse

Emerging economies, that had been resilient since the global financial crisis in 2008, are now beginning to buckle under the stress of the commodity meltdown and fall in global trade. The corporate earnings in emerging countries such as India, Brazil, South Africa, Indonesia, Malaysia and China have slid in the past one year. Amongst them, China and India are still better off with the fall in year-on-year earnings limited to less than 15%.

In contrast the corporate earnings of developed economies of Europe, US, Japan and Korea have registered double-digit growth in the last one year. But a comforting factor for emerging countries is that the strong corporate performance in developed markets is still not reflected in their economic growth that continues to remain anemic. On the other hand, developing countries like India are still posting robust economic growth and continue to attract foreign investors. But if emerging economies take a longer time to revamp their corporate performance in the changed economic climate, they face the risk of losing the favoured investment destination status. Not to mention, the rate hike by the US Fed will further skew the risk-to-reward ratio towards developed economies.

The Indian stock markets opened the day on a negative note and continued to trade weak during the course of the day. At the time of writing, the BSE-Sensex was trading lower by 203 points (down 0.7%). Banking & power stocks are the biggest losers today.

 Today's investing mantra
"The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Madhu Gupta (Research Analyst).

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2 Responses to "Checklist of an IPO Millionaire"

Anil Modi

Oct 29, 2015

You should publish a list of IPOs of the last three years, their sale price at which sold, their average market price of the next three years after being sold. This could provide illustrative information of the cheating techniques and the hand in glove relationship of the entrepreneurs, SEBI and the GOI ministries approving them.I wonder why at all public issues are approved at a premium while providing the companies an opportunity to trade their shares in the open market.If we are to grow properly it is of utmost importance that any promoter seeking money from the public is made responsible to make payment of the face value of the shares with interest in case its company does not perform to the extent of paying a minimum dividend after two years of the close of the public issue. I know it shall not please all those want to earn without earning.


Krishna Kumar

Oct 28, 2015

One of the criteria if an IPO will let you get good returns is if the product or service has any innovation component and if the spirit of innovation is in DNA of the company. Indian scenario as it exists today attaches no value to innovation due to ignorance . But Warren Buffet's view towards Google was a combination of ignorance and arrogance.

Equitymaster requests your view! Post a comment on "Checklist of an IPO Millionaire". Click here!
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