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IPOs: Is the skew justified?

Feb 25, 2005

Over the last couple of years, the primary markets have been one of the most successful hunting grounds for entrepreneurs. The table below that highlights the returns on some of the IPOs validates this argument. However, this is on the back of strong rally in the secondary markets. To put things in perspective, the BSE-Sensex has gained over 113% since the beginning of FY04.

IPO Boom
CompaniesIssue price (Rs)Listed price (Rs)Premium
Bharati Shipyard66.0 130.0 97.0%
NDTV70.0 101.0 44.3%
Indiabulls19.0 25.0 31.6%
TCS850.0 1,050.0 23.5%
NTPC62.0 70.0 12.9%

Response to the poll
Given the current spate of IPOs lined up, we asked investors as to why would they invest in the IPOs and the largest proportion (55%) of the participants voted in favour of short-term gains, while 36% of the participants voted in favour of fundamental reasons and the balance preferred to stay away from the primary markets.

Our view
The chart is fairly skewed in favour of investors who prefer to exit at the time of listing, which is concerning. This is because in a bull market, even the 'also run companies' make stupendous gains. In our view, there is more to the IPOs than just gains post the listing of the stock in the secondary market.

We believe that the Porter's Model fits the best as far as investing in stocks are concerned (be it new issues or already listed stocks). The various factors that an investor needs to/should consider are:

  1. Bargaining power of the supplier: The more diversified the supplier source, the better it is for the company. This is of more prominence for companies in the manufacturing sector as it helps these companies to source their raw materials from various sources at competitive prices. Since the suppliers face intense competition due to many players vying for the market share, it helps the company in terms of service quality (lower lead time) and raw material prices, thereby giving them better control of operations. All these factors do help the company in having an edge over competition. However, the better idea would be to go for backward integration, provided it is meaningful in terms of resources saved.

  2. Bargaining power of customers: It is important to view the products produced by the company from an economic needs and wants perspective. In other words, is the company producing goods, which are highly essential and the consumption of which cannot be postponed or given away. Companies with products, which have inelastic demand (where prices do not matter) witness weaker bargaining power in the hands of the customer. At the same time, in the case of durable goods, which have an elastic demand (which is price sensitive) and where consumption can be delayed, the bargaining power in the hands of the consumer is higher (airline tickets is a good example).

  3. Barriers to entry: One of the major factors considered during any feasibility study is the barrier to entry and exit. Any business that creates significant barriers to entry for competitors helps itself gain market share. Take for example, the scalability (ability to scale up resources) is a big barrier to entry for the software industry while on the other hand, the gas transmission and distribution business, the significant barriers to entry are their pipelines. The entry barriers help the investor understand as to how much time and resources would it take for a new player to enter similar business and to that extent, the gestation period. At the same time, absence of competition would help the first mover to take advantage of the situation in the business.

  4. Threat of substitutes: The aim of any company is to have an assured market for its product. This can be ensured in a way through product differentiation and value-adds. The threat of substitutes is usually seen in case of commodities and giffen-goods (low-priced and low value adds). Having a large number of substitutes provides alternatives to the consumer and therefore creates a virtual competition among the products. Take for example, tea or coffee, different brands of biscuits and breads.

  5. Competition: One of the major factors present in all the above forces is the competition in the business. Intense competition in the business takes away a lot of freedom from the organization in terms of product pricing, quality and costs resulting in pressure on margins at the operating level as well as the net income. Higher the competition, higher would be the benefit for the consumer. To second this argument, take the example of the FMCG sector, which witnessed intense competition over the last year resulting in a dip in the bottomline of the leader of the sector by over 30%. Pricing pressures on the back of penetrative strategy adopted by competitors and other regional players led to intense pressure on the operating level.

Finally, after weighing the company (coming out with the IPO) on these parameters, investors should take to the numbers in terms of the financial performance of the companies over the last few years and last but most important, the management.

Although in the booming market, short-term gains are huge, we believe this is just incidental and that the investment in an IPO should be based on the fact that the investor is buying the company's business, keeping in mind the above factors, rather than with the intention of making a quick buck. Buy the company's business rather than just the stock.

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