How to decide whether to invest in an IPO or not


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  • Author samco

Investing in an IPO has always been a point of discussion amongst investors and with the recent increase in the number of companies going public, the discussion is catching more attention. While this article attempts to answer the question, let us start by defining the IPO. An IPO is an offer in which a company decides to go public by getting themselves registered and listed on the stock exchanges. While investing in an IPO can be highly profitable since an “in demand” stock can increase in value many fold in a short duration of time, the decision is not always that easy.

This article is broken down into the following sections:

 

Self-Assessment
This section discusses the questions you should ask yourself before deciding whether to invest or not

 

Strong Fundamentals
This section talks about the various factors to consider when deciding to invest in an IPO

 

Risks
The risks involved in investing in an IPO are discussed here

 

Pitfalls
This section lists the mistakes you should avoid when investing in an IPO

 

Self-Assessment

Before even considering to invest in an IPO there are certain points of consideration which should be kept in mind. The answers to these questions play a crucial role.

  1. Would you be comfortable to own the stock if tomorrow the stock fell by 50%? The answer to this question will tell you how well diversified you are.

  1. How much percentage of your portfolio are you planning to invest and what is your risk tolerance? Investing in an IPO is a different ballgame and this question will highlight your exposure.

  2. Are you planning to invest in order to “flip” it or are you investing for the long run? This question focuses on your fundamental strategy going forward. Based on this answer, the types of IPO’s might change and your points of consideration might also.

Strong Fundamentals

No matter what your strategy is, considering certain factors is imperative before making a decision. Consider the following:

  1. DRHP – Your Bible

Every company is required to file a draft red herring prospectus (DRHP) with the Securities and Exchange Board of India (SEBI). Browsing through this document would give you insights into the financial and other information about the company. Usually, if the highest percentage of shares are held by institutional investors and banks, it could be a positive sign. A great deal could also be found out about the management of the company and its quality.

  1. Strong Promoters

Another important factor to consider is the entity which is promoting the IPO. It could be a company or an individual. Recognised names bring a certain credibility to the table and consequently, add a premium to the price. Another boost is when the company is government owned or is promoted by someone like the President. This indicates an extremely high level of safety when it comes to returns.

  1. Grading

The grading of an IPO is also as important if not more. Generally, higher grading is a positive indicator. Having said that, certain companies with excellent grades have withdrawn their IPO’s in the past whereas certain medium grade companies have performed excellently. Try not to look at the grading as an individual indicator.

  1. Objective

Where will the funds be used? What is the objective of the IPO? The answers to such questions could help judge the time frame of returns. The objective will also suggest the company’s future growth prospects.

  1. Do you understand the business?

As a general rule, it is advised not to invest in something you cannot understand.

Risks

Whenever you decide to invest in a company, there is a certain amount of risk involved. But one could term it as a “calculated risk” based on the past performance of the company, the sector trend and other factors and analysis. When you decide to invest in an IPO, it is like taking a leap of faith, because of two primary factors: Do you know enough about the company? And has the market had enough time to react and justify your buying price? These two questions pose a greater risk in IPO investing.

  1. What if the offer price is wrong and the market price is right?

This would indicate that the company is coming into the market at a relatively higher price. This might reflect the over optimism of the management.

  1. What if the offer price is right and the first day price is wrong?

In this case, the low first day returns indicates market inefficiency in the short term. This could lead to a downgrade of the stock and could affect the price in the long term.

  1. Absolute risk

This risk comes into effect if the company goes out of business.

  1. The honeymoon phase ends

IPO’s attract big attention on day one but then surprises could crop up. Data shows that from 1970 to 2012 the typical IPO gained just 0.7% in its second six months.

Risk factors are just like the small print you find in every promotion or document you sign; it is worth taking a look.

Pitfalls

While you decide to invest in an IPO be cautious of the following pitfalls.

  1. Rumors and success stories

While success stories and rumors present a very favourable case for the company, they should not be trusted. Always go by facts and figures rather than blindly believing on recommendations.

  1. Investing in Brand Promoters

IPOs with recognised brand names as promoters are not necessarily a great deal every time. Yes, a strong brand does help an IPO to create a buzz and hype but a strong brand backing an IPO is no guarantee of its future performance. Check the financials and verify if the numbers attest the image.

  1. Investing without an exit strategy (no stop loss)

This is a general rule and also applies to IPOs. Do not marry the stock if you realise you are in the wrong IPO.  Be prepared to cut your losses short and do not get emotionally attached just because you are invested.

Investing in an IPO has its risks so make sure you understand the prospectus properly before drawing any inferences.

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