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The type of investment you should definitely avoid - Views on News from Equitymaster
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  • Oct 5, 2009

    The type of investment you should definitely avoid

    The infamous IPOs are back once again. After the IPO fever ended with a huge number of investors burning their fingers in the Reliance Power issue of January 2008, new IPOs almost completely disappeared from the scene. All the hopeful companies waiting in line to come out with their own issues abandoned their plans almost overnight. Afterall, IPOs need a certain kind of optimistic environment to work their magic on people. And believe us, highly skeptical investors is the last thing they want.

    But now they are making a comeback. Even though investors are not as euphoric as the heady days of January 2008, a miraculous rebound in the markets from 8,000 to 17,000 on the Sensex has set the stage for expectations of a further up move. And that's perfectly the kind of environment that companies are always waiting for to come out with their offerings. In the last 4 weeks itself, 20 new companies have filed their draft offer documents with SEBI, surpassing the 15 filings in the rest of the entire year of 2009. We expect that to only increase in the coming days if the stock markets continue be as buoyant as they are right now. And with that, you can also expect a bombardment of ads, brokers and distributors, all trying to pep you up to apply.

    So how should you approach these IPOs? Is applying to IPOs a good way to create wealth?

    Those are important questions. But before we discuss the answers to these questions, here's a quick fact. Warren Buffett, one of the richest people in the world, and who has made all his wealth by investing in companies over the course of half a century, has never ever applied to an IPO. Is that any coincidence? Or do you think that's intentional?

    Yes, that is nothing but intentional. And if you would like to know why he does that, or who taught him to do that, read on...

    It was Buffett’s teacher and mentor Benjamin Graham that was completely against the idea of applying to IPOs. He had many well grounded and solid reasons for the same, and we shall endeavor to enumerate them in this article.

    There are all kinds of IPOs - the good, the bad and the ugly. But even though different IPOs are of different qualities, there are some general realities that Graham suggests one should keep in mind at all times.

    First off, if you need to be cautious while purchasing shares of a company from the secondary market, you need to be twice as cautious and wary while doing so in an IPO. The reason for this is that IPO's have a much higher amount of salesmanship and marketing effort put behind them when compared to shares that are already in the market. In fact, you may be surprised to know that investment bankers make significantly higher commissions to sell a new issue to the public than do brokers when you buy from the market. Thus if brokers have reason to be enthusiastic about having you keep buying and selling in the market, you can imagine just how much more motivation the investment bankers will have to make you apply for an IPO. And so, if new issues indeed have such a special degree of marketing effort behind them, its calls for a special degree of 'marketing resistance' from your side.

    Even more dangerous is the fact that this marketing tends to get progressively more stronger and aggressive as the issuing company gets smaller, riskier and expensively priced. This is all the more because the commissions that investment bankers make on an IPO tend to rise as the issuing company gets smaller and more riskier.

    Secondly, most IPOs are always sold under favourable market conditions. But the question you need to ask is - favourable to whom? For it is only logical that if it is more favourable to the seller to sell during those times, it has to be that much less favourable for the buyer to buy during those times.

    Many a times you will find that the companies coming out with IPOs have had a fabulous performance in the last 2 - 3 years. But if you go back earlier than that, this good performance might not have been the same. Even though one could make the assumption that the recent performance will continue without any serious setback, according to Graham this would be an unsound approach to investment, and one likely to prove costly.

    Further, there are many more IPOs in which the company has yet to make a single rupee in profits, but lays down elaborate and convincing plans about how and when it intends to become profitable. So what about them? Says Graham, "The more dependent the valuation becomes on anticipations of the future - and the less it is tied to a figure demonstrated by past performance - the more vulnerable it becomes to possible miscalculation and serious error."

    We conclude with an emphatic quote by Warren Buffett, which captures the essence of the entire argument as best as we possibly can. He says, "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).



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    6 Responses to "The type of investment you should definitely avoid"


    Oct 18, 2009

    Timely and neatly summarised article about IPO
    Pricing is very crucial.
    Retail investors should be thankful to u.


    Balasubramanian K

    Oct 18, 2009

    Your article is timely and highly informative. Many companies are rushing to get the SEBI-nod for their IPO ,obviously at highly irrational premium,to wipe out a part of their imaginary losses and to sell their present holdings of company shares and cheaply-bought lands at astronomical prices to their company, in the case of realty-companies. SEBI has proposed to come out with guide-lines for IPO-pricing,but only after a delay of over 6 months,so that these companies can get away with their loot,from an easily-gullible and small-investors ,ignorant value-based and return-based investment. Earlier SEBI had miserably failed to protect investors from many highly priced IPOs like ReliancePower,Uttam Sugar etc, to quote a few, which are now available at abysmally low prices, with no prospect of a dividend in the foreseeable future. Many investors don't even read newspapers like ET, which aim to caution them from such day-light robbers,looting the investors of their savings,with SEBI looking aside with connivance that cannot be proved. The MOF must direct SEBI to put on hold all DRHPs ,till it comes out with their guide-lines. Heaven will not fall on them if these companies are made to wait a few more months, but investors will be saved.Can we expect SEBI & MOF to act atleast now in their only role to protect uninformed investing public ?



    Oct 14, 2009

    Congratulations on a nice article.This has come at a right time as market is expected to be flooded with IPO's in coming days.


    Sarda Ram Karsania

    Oct 13, 2009

    13th Oct.2009
    Valuable advice given to the investers at the right time.
    We should be morecareful in investing our hard earned money.
    Thanks and regards.


    K. Sankara Narayanan

    Oct 10, 2009

    Your advice on Investment to be avoided has come at an appropriate time & is a Wake up call to gullible retail investors.
    Oil India is an exception and IPO's of PSUs are to some extent an exception as no group is going to profit from it.
    Rating of new issues needs to be made mandatory.
    We retail investors are thanful for this timely RED SIGNAL.



    Oct 7, 2009

    Excellent article. Neatly summarizes Buffet and Gharam's thoughts. I really like your ever cautious approach towards investing that you keep suggesting to everyone. Keep up the good work.

    I would also like to see one article from your side on Shares with Differential Rights given their dismal performance in India.One more on Right issues if you can manage. All these instruments are anti investor but sold to general public at huge cost. Irony is that like in case of IPOs, it is public which funds commission of I-Banks because their cost is also included in IPO proceeds expected by company. Amazing structuring these bankers do to fill their pockets depriving millions of investors.

    What I found missing in above article was role of HNIs and FIIs who dump share on the listing day itself onto general public. Though concept of Anchor investor is a better one but not sufficient to address the root cause of the problem. Hope you would shed more light on these aspects in your next article.

    Happy investing!

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