Do you like taking unnecessary risks? With money? I am not sure about your answer but mine is that I don’t. Ofcourse we cannot eliminate the risks in stock market investing. But lower the risks are, better I feel. In previous post about why being smart is not necessary to be rich, I explained why having a super IQ + intelligence might not protect your investments.
We need to understand that we can afford not to be a great investor. But we cannot afford to be a bad one. The downside of being bad are pretty, bad. There is no need to take unnecessary risks if you don’t know what exactly is being offered in a deal. You can always choose to walk out of a deal you don’t understand fully. Instead, take the 2nd best strategy if that works for you more than the best one.
I know many cases where people have lost all money in stock markets. Then there are those who are waiting to recover money lost in stocks, even after years (and in rare cases, decade). Even the financial companies at times (rather most of the times) try to fool you. Read thisfor a real-life incident.
And who can forget the IPOs? Designed specifically to not-benefit only one category of people – new investors. 🙂 The promoters know more about their companies than the small investors. They only come out with IPOs when they know that they will be able to sell at prices, which are higher than actual intrinsic value. Now when the prices correct in line with actual value, the small investors get hurt. Then promoters come back with buybacks, open offers and delisting proposals. So all in all, its quite unfair. But people still take the IPO route when they see any recent trend of IPOs doing well.
In secondary markets, most investors participate with the wrong mentality. With share prices going up and down on a daily basis, there is an urge to act and benefit from volatility. But most investors lack the capability to make the right decisions under such levels of uncertainty. They let emotions take control of their portfolio and end up ruining it.
Another reason why some people always end up losing money is that they bet something important to get something unimportant.
Lets take an example.
Suppose you have to send your child to college in 5 years. You know that you will need Rs 15 lacs for that after 5 years. You have already saved up Rs 10 lac and are also regularly saving Rs 7000 a month. This will easily let you achieve the target of Rs 15 lacs in 5 years, even if you don’t earn anything on Rs 10 lac that you have already saved.
But your high-flying, high IQ financial advisor tells you that a particular sector is expected to do well in coming years. And you can benefit from this once-in-a-lifetime-opportunity by investing in some sectoral fund. You think about it and invest the already accumulated Rs 10 lacs in the sector fund. Unfortunately, the sector doesn’t turn out to be a once-in-a-lifetime-opportunity and your investment goes down to Rs 7 lacs after 5 years.
You gambled because of your greed, ignorance or whatever. You risked something important for something that was not.
Buffett once used the example of Long Term Capital Management (LTCM) to explain about taking unnecessary risks. This is what he had to say (emphasis mine): ______
“…If you take the 16 of them (LTCM’s people), they probably have the highest average IQ of any 16 people working together in one business in the country, including Microsoft or whoever you want to name – so incredible is the amount of intellect in that room.
Now if you combine that with the fact that those 16 have had extensive experience in the field in which they operate. I mean, this is not a bunch of guys who made their money selling men’s clothing and all of the sudden went to the security business or anything. They had, in aggregate, probably 350 or 400 years of experience doing exactly what they were doing.
And then you throw in the third factor: that most of them had virtually all of their very substantial net worth in the business.
They have their own money tied up, hundreds of hundred of millions of dollars of their own money tied up, a super high intellect, they were working in a field they knew, and they went broke.
And that to me is absolutely fascinating.
If I write a book, it’s going to be called “Why do smart people do dumb things?
To make the money they didn’t have and they didn’t need, they risked what they did have and did need – that’s foolish, that’s just plain foolish.
If you risk something that is important to you for something that is unimportant to you, it just does not make any sense.
I don’t care whether the odds are 100 to 1 that you succeed, or 1000 to 1 that you succeed.
If you hand me a gun with a thousand chambers or a million chambers, and there is a bullet in one chamber and you said ‘put it to your temple and pull it’, I’m not going to pull it. You can name any sum you want.
It doesn’t do anything for me on the upside, and I think the downsize is fairly clear.
I’m not interested in that kind of a game, and yet people do it financially without thinking about it very much.
It’s like Henry Kauffman said the other day – the people going broke in these situations are just two types: the ones who know nothing, and the ones who know everything.”
Coming back to the example of funding your child’s education, you can easily blame bad luck for getting screwed up.
But is it really bad luck? I don’t think so.
Its rather a case of what this quote by DW Jerrold says:
Some people are so fond of bad luck that they run halfway to meet it. 🙂
So what is it that takes to save your money from yourself?
There is no set formula to not lose money. Also being smart is a good thing. But don’t be oversmart when it comes to money matters. Don’t do stupid things because you are greedy or impatient.
There are things you don’t know and more importantly, there are things that you don’t know that you don’t know! That is where the biggest risks lie. Make buffers for such unknown-unknowns. Also make buffers for known-unknowns like death.
Be aware of the potential downsides of your decisions. The potential upside is totally irrelevant if the downside is bankruptcy or death (as in case of Buffett’s gun example).
And as David Houke of Alpha Architectsays, there are certain bets, regardless of how asymmetric they may appear, that should be beyond consideration by a reasonable and prudent actor. The second thing that can protect you is an awareness of what the potential monetary upside actually means to you, in practical terms.
The second point is really important. What is that you are after? Does taking the additional risk actually help you in any other way apart from adding some extra money to your wallet? What is the true effect of additional returns on you and your life circumstances? It’s a question worth asking.
Another IPO got oversubscribed few days back – that too 70+ times oversubscription – I so wish that I was the seller 😉
In recent times, the number of IPOs coming out has increased and more importantly, many of them are witnessing significant oversubscription – clear signal that appetite for IPOs is returning to the markets.
This optimism is fueled primarily by the recent upmove in secondary markets.
IPOs are known to generate a lot of emotions – both good and bad depending on how previous few IPOs have performed.
Why are IPOs Overpriced?
Now if I own a company, which is about to go public with an IPO – which means I need to sell my shares to get money – then I will make sure that me and everyone else in my team, will do everything to ensure that I get the highest possible rate for each and every share that I want to sell.
This is not greed. This is what any normal person will do.
And that is exactly what a promoter (original Investor) does during an IPO.
Now lets turn around the table.
The ‘above mentioned’ promoter is selling his shares to new investors (i.e. you).
As already mentioned, his primary aim is to get the maximum amount of money for his shares.
He, with his investment banker friends sets the issue price. Remember that he still has his primary aim in mind, while setting the IPO price band.
Now as an IPO investor, you end up paying as much as the promoter wants – i.e. a lot more than what is financially necessary.
This is how IPOs work.
Few weeks ago, I read the news about how L&T had decided to withdraw the DRHP for its subsidiary L&T Infotech’s IPO. Among others, one of the reasons quoted for this withdrawal was that the valuations of company were very expensive and did not suit current market conditions.
Now just think about it.
Even the company felt that it had overpriced its share sale! 🙂
Had the company decided to come out with the IPO instead of withdrawing, the investors would still have paid the expensive prices for the shares on offer.
Atleast in this case, the company withdrew its application. But in most cases, companies go ahead with their overpriced IPOs. Why say no to money coming in?
Most IPOs fail to give good returns to investors. Most promoters tend to price their public issues in a way that leaves little or almost nothing on the table for long-term investors.
I recently read in a business daily that for most IPOs, listing day gains are better than one-year returns. If that is true and my guess is that it is – then it speaks volumes about how IPOs are priced.
Talking in reference to the mistake people make in IPOs by ignoring ‘Base Rates’, noted value investor Sanjay Bakshi said:
‘Base rate’ is a technical term of describing odds in terms of prior probabilities. The base rate of having a drunken-driving accident is higher than those of having accidents in a sober state.
So, what’s the base rate of investing in IPOs? When you buy a stock in an IPO, and if you flip it, you make money if it’s a hot IPO. If it’s not a hot IPO, you lose money. But what’s the base rate – the averaged out experience – the prior probability of the activity of subscribing for IPOs – in the long run?
If you do that calculation, you’ll find that the base rate of IPO investing (in fact, it’s not even investing…it’s speculating) sucks! It’s that’s the case, not just in India, but also in every market, in different time periods.
Now I remember that in 2014, Indian Oil’s disinvestment was being deliberated by the government.
But eventually, the Petroleum Ministry rejected Department of Disinvestment’s idea of the stake sale. The publically acknowledged reason being the huge undervaluation in share prices.
But think about it.
Would it not have been a good time to buy shares of that company? I thought so it was (Read why)
The promoter’s representative (Oil Ministry) was unwilling to sell shares due to undervaluation – even when the government (actual promoter) was forcing it to (for reasons ranging from trying to reduce its fiscal deficit by selling stakes in PSUs to what not…).
The stock of the company was then trading close to Rs 190. Now the same is above Rs 400. Ofcourse low crude oil prices helped as the company belonged to the downstream sector. General rise in markets too acted as a solid tailwind.
But what I am trying to highlight here is that when promoters are not willing to sell (unless absolutely necessary), then that is a good time to think about buying. It’s a sort of corollary to the idea of stocks being undervalued (in eyes of promoters), when promoters are buying back shares.
Exactly opposite is the case during IPOs. Promoters are willing to sell their shares. So they would want to get as much money as they possibly can. This is against the interest of long term investors.
Now I already said this in a post few years back and I say it again: the very purpose of a company to do an IPO is to raise as much money as possible. They are not here to do any favors to anyone. They need money and want to have as much of it as possible.
If you have been in markets for last few years, you would have observed that the number of IPOs increase, when markets are in an uptrend.
That is quite obvious as during bull markets, the perception of stock markets being a place of easy money becomes strong. This in turn helps IPO sellers to sell the IPO as dreams to potential investors. Investing in IPOs during bull markets can still be a profitable endeavour. But then again, IPOs during those time get hugely oversubscribed and allocation is pretty small. At times as low as being negligible, when considered in comparisons of overall equity portfolio.
Many people suffer from the Fear Of Missing Out (FOMO) syndrome, which pushes them towards IPOs. They put money in IPOs with the hope of making some quick gains and then boasting of high CAGRs. But for most people, hope is not a good strategy. If you are lucky, you might make money. But odds are stacked against common investors in IPO.
Older investors tell that the scene of IPOs has completely changed in India. Earlier, it was possible to make decent profits as issuers were not free to set IPO pricing – which was controlled and decided by the Controller of Capital Issues.
But now, its another ball game.
Though there is no strict IPO overpricing definition, fact is that majority of IPOs are not priced fairly – from IPO investor’s perspective. Or to put it simply, the scale of underpricing and overpricing of IPO, is skewed towards overpricing.
IPOs are built around hype and stories. And many are fairy tale stories. 😉 As the bull markets go higher, almost every story is able to excite the investors. Compelling stories allow expensive price tags to be attached to these IPOs.
But most of the (IPO) stories are not true – just like in real life. But problem is that these stories and hypes disrupt proper investing behavior.
Stories alone cannot keep the prices up. One day or the other, business does catch up with the price. Or rather, prices come down to levels of the real story behind the business. 🙂
And this is not something new.
Hype was that caused Tulip Mania in the 1600s. Remember Reliance Power’s IPO? The company was selling the hope that it will construct power plants and change the power sector forever. It was a one of the biggest IPO overpricing example in Indian history. Very few even bothered to have a look at NTPC, which was available way more cheaply and had actually set up large power plants!
It is amazing how people will not do simple things to make money!
In general, IPOs are only launched keeping in mind the interest of existing promoters and investment bankers. There is a reason why they tell you to read the offer document carefully before investing. 😉
If you are a long-term investor, you are better off looking for good stocks in already-listed stock space.
In fact, one of the big incentives for an IPO is so that previous investors – founders, venture capital firms, and large individual investors – can “cash out” at least a portion of what they’ve invested. That is why most IPOs are often expensively priced.
Now Warren Buffett has been quite vocal about his distaste for IPOs. This is what he had to say in a letter published in 1993:
…intelligent investor in common stocks will do better in the secondary market than he will do buying new issues… market is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of public…
11 years later (in 2004), he had some more wisdom to share about the IPOs:
An IPO is like a negotiated transaction – the seller chooses when to come public – and it’s unlikely to be a time that’s favorable to you. So, by scanning 100 IPOs, you’re way less likely to find anything interesting than scanning an average group of 100 stocks.
The seller of a $100,000 house in Omaha will never sell for $50,000. But if 100 entities each owned 1% of a basket of homes in Omaha, the price could be anywhere.”
At the end of the day, it comes down to the need for investors to understand – that IPOs are designed to benefit promoters more than investors. If they don’t understand this, they will eventually end up loosing money.
And as Late Parag Parikh said:
If consumers are irrational it makes sense for companies to cater to that belief rather than eradicate it.
Sounds logical to me. 🙂
Now its possible that going forward, markets might show signs of further revival. This in turn, would mean that companies would become ready to come out with their IPOs and FPOs.
The IPO sellers will start projecting these new companies as investments that can take you portfolio to the sky.
But remember, that the IPO sellers have the luxury of deciding the timing of the sale, i.e. they can choose to sell only when they get high prices for the shares. And that is what they will do.
Now for a moment, give it a thought. Why don’t IPOs come in Bear Markets? Or why does the number of IPOs hitting the market fall down when markets are not rising?
Mr. Parikh once said:
Companies don’t want to sell their shares in a bear market because they won’t be able to get a good price. But then where is the logic for investors to buy these shares in a bull market, when valuation is high?
I am sure that many people will still be interested in investing some money (say sin money) in IPO.
I am not stopping you.
Please go ahead and do it.
But just remember that you are buying shares from someone, who knows much more than you about what he is selling, has done everything (right and wrong) in last 1-2 years to make the financial statements look good, paid good money to merchant bankers to spread good words and stories about the company.
As IPOs in initial phase come out and start trading at significant premiums to their offer price, this gives a confidence boost to the next line of not-so-good companies, waiting to tap the market.
So the momentum continues to build up unless it stops. And as noted professor Aswath Damodaran says, the IPO game is a subset of the momentum game. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers.
So keep you eyes, ears and place where common-sense resides, open. 🙂
To be fair, there have been some good issues in the past and its possible that good companies might come up with an IPO that is worth investing. But identifying the ‘goodness’ of the company in itself is a very big task.
Most IPOs are not good for most investors – and hence, there is no reason for common investors to try and portray that they know the value of company better than the person who is selling his stake in the IPO.
The Economics of IPO (and other) Markets (by Sanjay Bakshi)
You can read the full article here. Or can go through some IPO relevant extracts below:
Any kind of rational comparison of long-term returns in the IPO market and the secondary market would show that investors do far better in the latter than in the former. Indeed many such comparisons have been done which cover data taken from several countries spanning over decades. The conclusions are always the same: that IPOs are one of the surest ways of losing money in the long run.
There are certain characteristics of the IPO market, which makes it unattractive for long-term investors.
The IPO Market It is only to be expected that in a bull phase of the stock market, there will always be a sector, or a group of sectors, which are viewed extremely favourably by the investment community. These favourable views of the investment community are expressed by it in the form of high price/earnings, price/book value, price/sales and price/cash flow ratios commanded by the stocks of publicly owned and quoted companies.
At this time, privately-held companies in such sectors find that they possess an unlimited supply of extremely desirable “merchandise” i.e. their own shares.
Naturally, merchant bankers scramble to advice these companies on how to raise a large sum of money from the equity markets at inflated prices. (The recent development of book building for IPOs is nothing but an artful form of pitting one bidder against another in an attempt to create a high clearing price for the shares being offered).
Four characteristics of the IPO market make it a market where it is far more profitable to be a seller than to be a buyer.
First, in the IPO market, there are many buyers and only a handful of sellers.
Second, the sellers, being insiders, always know more about the company whose shares are to be sold, than the buyers.
Third, the sellers hold an extremely valuable option of deciding the timing of the sale. Naturally, they would choose to sell only when they get high prices for the shares.
Finally, the quantity of shares being offered is flexible and can be “managed” by the merchant bankers to attain the optimum price from the sellers’ viewpoint. But, what is “optimum” from the sellers’ viewpoint is not the “optimum” from the buyers’ viewpoint.
This is an important point to note: Companies want to raise capital at the lowest possible cost, which from their viewpoint means issuance of shares at high prices.
That is why bull markets are always accompanied by a surge in the issuance of shares. It is true that often hot IPOs list at incredible premiums. The reason is simple: the demand for the shares being there, the merchant bankers ensure that only a limited supply is released to ensure a high price on listing.
Super profits are made by those who get shares allotted to them in the IPO, so long as they sell them at, or soon after, the initial listing.
This is where the trouble begins. Everyone wants a piece of the hot IPO cakes. Everyone thinks that he will get out at the top. Mathematically speaking, obviously this cannot be true. Moreover as time goes by, the investment quality of the issues tends to deteriorate.
Alibaba recently did the largest IPO in United States’ history. And the $21+ Billion IPO was just a notch lower than the largest one ever done in the world. And with listing day gains of almost 38%, the company now has a market cap of $230 Billion. Compare this with our Indian giant TCS’s market cap of $85 Billion and you will understand the massiveness of the number.
For those who are not aware of what Alibaba does, the following headline in Wall Street Journal will be a good starting point:
A Mix of Amazon, eBay, Paypal with a Dash of Google.
You can click the link above to know more about the company. And chances are that this simple description may not be 100% accurate or complete. But this post is about something else.
I was going through Professor Aswath Damodaran’s coverage of Alibaba (link), when I came to know about a very interesting fact about this IPO, and the Chinese company’s ownership laws in general.
When you (or anyone in US) buy shares of Alibaba, then it does not mean that you get a part ownership in the company.
So what exactly is that investors are buying into?
And I quote the professor:
You are not getting a piece of Alibaba, the Chinese online merchandising profit-machine, but a portion of Alibaba, the Cayman Islands shell entitythat has a contractual arrangement to operate its Chinese counterpart. While the Chinese government has granted legal standing to that contractual agreement, at least for the moment, it reserves the right to change it’s mind and if it does, Alibaba’s shareholders will be left with just the shell.
Source: Prof Aswath Damodaran’s Blog
And that is because the Chinese government restricts foreign ownership of key strategic assets. And like Alibaba, many other Chinese companies get around this using a complex structure – Variable Interest Entity or VIEIn Alibaba’s case, the VIE is based in the Cayman Islands and is entitled to the profits that Alibaba in China generates.
As far as the management is concerned, Alibaba uses the above structure to take away any right whatsoever from the shareholders, which could affect the choice of people joining its board. The Board will be named by a group of partners and shareholders will have no say in it. Period.
So much for investing in a red hot IPO… isn’t it?
So what notes can average Indian investors like us take from this?
I ask this because very soon, investors would be falling head over heels to get shares in IPOs which are scheduled to hit Indian markets in coming months.
And it is that when you plan to invest in shares of a company, that too of a company going for a new listing, make sure you know more than just about nature of business of the company. You should know whether you are actually getting what you are made to believe. In Alibaba’s case, its much safer and you have a visible, full-fledged, massive, cash-generating business.
JustDial is an online Indian search engine. The company is coming out with an IPO with a price band of Rs 470 to Rs 543. To voo retail investors, it is offering a 10% discount and a safety net, which would be triggered in case share prices fall 20% below the issue price. At this juncture, promoters would be forced to buy back the shares from retail investors at issue price.
Just Dial IPO – Is it worth investing?
CRISIL believes that company’s business model is great. It has gone ahead and assigned a rating of 5/5 to the issue. But with Google being one of the major competitors of JustDial, we don’t agree with what CRISIL has to say. By the way, ratings should always be taken with a pinch of salt. ReliancePower’s IPO was assigned a rating of 4/5. And we all know what happened. 🙂
But there are a few other things which concern us…
Sometime in 2012, company’s CEO VSS Mani made a remark – “The IPO (initial public offering) next year will just be a liquidity event for our investors.” Nothing wrong with that. Our only concern is that if you invest in this IPO, you will be on the receiving end of this liquidity event 🙂
We are not sure that we would like to have Google as a competitor in the businesses we invest. Just a little effort by Google in Indian markets can cause a lot of trouble for JustDial.
The online space has very low entry barriers. Anyone can come up with a better solution than JustDial. It is a fast changing landscape. And any adverse developments on the technology front can make this stock volatile in times to come.
With EPS of around Rs 9, JustDial would be available at multiples of 52x to 60x. And that is damn expensive!! Something like a Google trades at 25x multiples. Just imagine the growth rate which the company would need to maintain to justify these multiples!! And if we are really interested in buying something at 50x multiples, why wouldn’t some go for a much better and established businesses like HUL or an ITC?
CRISIL’s IPO grading only looks at company fundamentals relative to peers. It tells absolutely nothing about its valuations.
Lets talk about the safety net which company has proposed.For this, there is a defined safety net period of 180 days from the date of listing. The safety net gets triggered if the weighted average market price of equity shares in the 60 days after the safety net period gets over is lower than the allotment price. If this happens then the safety net providers, in this case promoters of the company, will buy back shares from the original retail shareholders at the retail offer price. The point to note here is that company is not offering too many shares for the retail investors. So the benefits of overpricing this IPO far outweigh the possible losses in case of trigger of safety net option. So this is more of an eyewash by the company.
Mr Amitabh Bachchan (who has done a few ads for the company) has received 67,000 plus shares of the company at just Rs 10. Not sure if this was part of the compensation or his investment acumen 🙂 But he is getting an option to sell his shares in open market for 5000% profit. Same shares which he bought (or got) at Rs 10, is available to us for Rs 500 plus. We don’t like this 🙁
Lucky him Or Unlucky you?
Not sure what retail investor’s response would be, but we are sure that we don’t like this issue. It may go up in the short term because a rising tide lifts all the boats. And with current markets looking to move up, anything might be possible. But we might get interested in this business again when prices would have cooled down [substantially]. Reason for our interest would be the uniqueness of the business, which has a negative working capital cycle. The company collects 100% of the money from its customers upfront. But no point discussing these things till share prices go down (& profits go up). Lets see how the issue pans out 🙂
Do you remember the days when you submitted your IPO applications thinking that you will sell your allotted shares on listing day for a handsome gain? But after listing, prices never moved above the IPO price… Or worst still, they fell so much that you decided never to invest in IPOs again. We all remember what happened to Reliance Power’s IPO, isn’t it?
Example of IPO overpricing : Reliance Power
So why it is that IPOs are more of a losing proposition? Why is it that they say that the word IPO, does not stand for Initial Public Offering..
It stands for…
It’s Probably Overpriced (IPO)
You may say that you made money in IPOs of Coal India, Mundra Port, Career Point, CARE Ratings etc. We don’t deny it. Even we made a killing in a few of the IPOs. But largely speaking, IPOs tend to be overpriced. And when we gave a thought to it, it actually made a lot of sense.
Source : Google
If you give a serious thought to why companies go for IPOs, you would understand that the whole point of going for an IPO is to overprice the share offering!! The very purpose of a company to do an IPO is to raise as much money as possible. They are not here to do any favors to anyone. They need money and want to have as much of it as possible. For a moment, let’s digress from the IPOs and assume that you want to sell your house. You will try to get the maximum out of the buyer, isn’t it? It’s natural. Everyone wants to get a better deal.
So if you are an investor (or rather a trader looking for short term profit), and have burnt your fingers in any of the recent IPOs, then you have only yourself to blame. It’s because you have misinterpreted the primary purpose of an IPO.
Note – Not all IPOs may be overpriced. You need to do you due diligence before investing your hard earned money.
Disclaimer: No positions in any of the above mentioned stocks.
As soon as we read this, we had a feeling of Déjà vu…
Déjà vu, according to Wikipedia, is the phenomenon of having the strong sensation that an event or experience currently being experienced had been experienced in the past.
You must be wondering why? The reason is…
2008 – Reliance Power’s IPO – About 2 Billion Dollars – Sensex near All Time High
2013 – NTPC’s Offer For Sale – About 2 Billion Dollars – Sensex near All Time High
Power Stocks : Deja Vu??
Striking similarities, isn’t it? Both companies belong to power sector, both are coming out with almost equal offer sizes and markets in both cases are trading near all time highs.
But similarities end here and there are some marked differences too:
In 2008 (Jan-Feb), Sensex was trading at multiples of 24x. As of today (Jan-Feb 2013), Sensex is closer to 19x.
Reliance Power did not have any assets at the time of IPO (2008). On the other hand, NTPC (2013) has an installed capacity of about 40,000 MWs.
We should pray that similarities end here itself. This is because if what happened after Reliance Power’s IPO (Great Crash of 2008-09) gets repeated in 2013, once again there would be massive erosion of investor’s wealth and confidence.
Disclosures: No positions in Reliance Power or NTPC.