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Are you investing in IPOs? - Views on News from Equitymaster
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  • Feb 16, 2005

    Are you investing in IPOs?

    The Indian stock markets continue to make newer highs on the back of strong FII inflows, which is a factor of the seemingly strong economic prospects in sight for the country. Stock prices continue to soar and are making new 52-week highs consistently. There is everything positive at the current juncture for Indian equities and this has been attracting investors to equity markets.

    Taking advantage of this gung-ho environment in the stock markets, many companies time their IPOs during such periods, as they are able to 'price' higher than they would have otherwise when the scenario is not favourable for equities. In this article, while we would refrain from commenting on whether one should invest in an IPO or not, we look at one important aspect of investing in an IPO and jot down a few points that investors need to remember.

    As per reports, Indian markets are likely to see IPO offerings worth Rs 250 bn in 2005. Considering that approximately 25% of every issue is for retail investors, it implies that this category of investors would need more than Rs 60 bn to invest in the same. Further, considering that in bullish times, IPOs could get oversubscribed several times (including the retail portion). This, in turn, gives rise to larger amounts being invested by investors so as to increase the chances of allotment in case of over-subscription. But the question is, does the retail investor have so much money to invest?

    This is where IPO Margin Financing (IPOMF) comes into the picture. It must be noted that while an individual may have limited funds, there are various banks and financial institutions that are willing to lend money, at a certain interest rate, so that you can invest in an IPO. Thus, IPOMF basically facilitates an investor to invest beyond his/her capacity (leveraged investing). An investor prefers to apply for more shares during bullish times not only to increase his chances of getting some allotment but also on the belief that he will be able to make handsome return on his investments. However, it is not as simple as it seems. This factor needs to be considered in a little more detailed manner so as to understand how IPOMF will affect your returns.

    Company XYZ
    Offer price (Rs/share) 100
    You want to apply (nos. of shares) 1,000
    Investment required (Rs) 100,000
    You have (Rs) 25,000
    IPO Margin Finance (Rs) 75,000
    Interest & other charges on margin finance 2%
    Interest & other charges (Rs) 1,500

    The table above indicates the details of an investor wanting to apply in the IPO of a company XYZ whose offer price is Rs 100 per share. The investor intends to apply for 1,000 shares for which the investment required is Rs 100,000. Since he does not have the capacity to invest the full amount, he opts for IPOMF of Rs 75,000, wherein the interest and other charges add up to 2% per month on the borrowed funds i.e. Rs 1,500. Below are discussed a couple of possible scenarios considering that an investor gets some allotment.

    Case 1
    Allottment (nos. of shares) 1,000
    Total investment incld. interest (Rs) 101,500
    Cost of acquisition (Rs/share) 102
    Selling price (Rs/share) 110
    Returns on investment (%) 8.4%

    Case 1 above assumes that the investor is lucky enough to be allotted all the 1,000 shares he had applied for (a scenario very unlikely during such bullish times). Thus, taking into consideration the interest on the borrowed funds, the cost of acquisition per share would be Rs 102 (rounded-off) and not Rs 100. It must be noted here that the entire interest expense of Rs 1,500 is spread over 1,000 shares. Now assuming that the stock lists at Rs 110 (10% premium to the offer price) and the investor decides to book his profits, he would be happy with the 8.4% gains he has made on his investment.

    Case 2
    Allottment (nos. of shares) 100
    Total investment incld. interest (Rs) 11,500
    Cost of acquisition (Rs/share) 115
    Selling price (Rs/share) 110
    Returns on investment (%) -4.3%

    Now let us consider another scenario (case 2) wherein an investor is allotted only 100 shares (a much more likely scenario, especially in times when even 'me-too' IPOs get oversubscribed multiple times). In this case, the interest cost (already pre-determined and fixed) is spread over the 100 shares. It must be noted that the interest charged by the lending entity applies to the entire borrowed funds, irrespective of whether you are allotted all, few or nil shares. This effectively increases the cost of acquisition per share to Rs 115. Thus, at Rs 110, the investor is actually at a loss of 4.3%.

    While both the above cases are hypothetical and the final scenario would depend on various parameters like shares allotted, interest on IPOMF and selling price, we have made an attempt here to bring out the complexities. Further, it must be noted that there is always a possibility that an investor may get carried away and over-leverage himself, thus putting his financial viability at risk.

    While the above is just one of the parameters that must be kept in mind while investing in an IPO through the margin financing route, there are various other fundamental parameters that must be borne in mind even otherwise. These include:

    1. Who are the Lead Managers to the issue? Do Lead Managers act as an indicator of the quality of the issue?

    2. What is the promoter holding in the company? Is there any participation from financial institutions or a venture capital firm?

    3. Where is the company investing my money? Is it going to give me good returns?

    4. Which sector does the company operate? What is the growth prospect of the company vis--vis the sector?

    5. Do the promoters have enough experience?

    6. Will the money invested yield maximum returns? Are the profit projections achievable?

    7. How do I justify the price of the issue?

    8. Does the company enjoy tax benefits?

    All these questions are explained in detailed in our article: Checklist for IPO investors

    To conclude, we believe that before investing into equities (either through personal or borrowed funds, through secondary or primary markets), certain key issues like assessing one's own risk bearing profile, the investment time horizon and fundamentals of the company must be strictly adhered to. After all, its your money, honey!.



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