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How to Profit from IPOs

Sep 13, 2016

In this issue:
» A Handbook of IPO Investing!
» RBI Builds a Forex War Chest.
» ...and more!
00.00
Rohan Pinto, Research analyst

IPOs are exciting. There's no denying it. A private business owner brings their company to the market. And the owner 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 the 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 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 mean Initial Public Offering. They should rather be called '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.

How massive?

Here are a couple of examples. The first is among the most well-known companies on Earth. The second is one of our very own Hidden Treasure recommendations.

The Coca-Cola Company went public in 1919. The price was US$ 40 per share. If you bought one share then, it would be worth approximately US$ 400,000 today. That's a 10,000 bagger! If you had re-invested the dividends, your holding today would be worth more than US$ 15 million! That's almost unbelievable, but it's true. The Coke IPO changed many people's lives.

But here's something that's even more interesting.

The stock fell to US$ 19 in the very first year! The IPO investors who endured this pain were rewarded beyond their wildest dreams.

Want a similar example from the Indian market?

Okay.

The timing of this stock's IPO was perfect for the promoters but horrible for investors. Just like Reliance Power, it hit the market in January 2008. In the bear market that followed, the stock fell by more than 80%. The stock in question is eClerx Services.

What returns did the IPO investors get if they had held on to eClerx till today? Well, with a return of about 22% CAGR, excluding dividends, they have done quite well in our view.

So this means it is possible to make big money from IPOs. But only with the right company. At the right price.

How can you decide which company is the right one? Would you like to adopt the approach of an enterprising investor? We have good news.

Some huge IPOs are coming up, including the first IPO of a pure play insurance company in India - ICICI Prudential.

To help you approach them as an enterprising investor would, we are preparing special handbook for IPO Investing. Watch this space to know how you could access it...

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04:10 Chart of the Day

According to the weekly statistical supplement released by the Reserve Bank of India (RBI) on 9th September, India's foreign exchange reserves have continued to soar over the past couple of months and have now almost reached US$ 368 billion. Foreign currency assets, which includes the US dollar and other non US currencies, totalled US$ 342 billion, while gold reserves stood at US$ 21.6 billion.

India's Foreign Exchange Reserves On the Rise


The country's reserves have increased by US$ 5.1 billion from 22nd July. The reserves have gone up supported by strong dollar inflows which helped the central bank to add more dollars to its reserves to prepare for the FCNR outflows that are expected during the September-November time frame.

The central bank had earlier stated that the FCNR deposits repayment could result in an estimated outflow of about US$ 20 billion. The central bank said that it would supply dollars to the markets in case there is extreme volatility but the market participants should not take this intervention for granted. The gradual mopping up dollars by the RBI looks like the central bank is taking no chances and has the ammunition i.e. the supply of dollars ready in case the markets require them.

04:40

By the way, Vivek Kaul has just written a superb piece about EMIs and rents in real estate. India's Finance Minister recently reminisced about the good old days when rents and EMIs were almost the same. Vivek, explains why this is a pipe dream today! You can read it here....

04:50 Today's Investing Mantra

"If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rohan Pinto (Research Analyst).

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Equitymaster requests your view! Post a comment on "How to Profit from IPOs". Click here!

2 Responses to "How to Profit from IPOs"

VIRENDER SINGH

Sep 16, 2017

will you please tell me that how to determine a particular ipo is how much benefecial(multibagger)or not,to the investor.

Like 

Chandravinod Pathak

Sep 18, 2016

Sir.
Sub: How to profit from IPO ?
You rightly said that IPOs are for the profit of the sellers or offerers.
Mostly,your comments go on and on. Your comments set up a trap and lure investor so that you sell your books.
All the statistics and charts are theories having fifty-sixty percent chance.
Also you write good English with excellent story telling skills.
I am wondering, you will be millionaire with so much information. Tell us about your personal success or failure in investments.
Regards.

Like (7)
  
Equitymaster requests your view! Post a comment on "How to Profit from IPOs". Click here!
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