The Hindu Business Line : What to look out for in IPOs

Initial public offers in buoyant markets often price in earnings for the first few years, leaving thin margins of safety and room for disappointment.

Bhavana Acharya

Over the past nine years, almost 300 companies have collectively gathered more than Rs 132,000 crore in the capital market through IPOs. However, the long-term track record of IPOs in the Indian market suggests that a large proportion of them do not deliver on the initial promise.

A Business Line analysis of all IPOs from 2000 to early 2008, shows that one out of every two IPO stocks still trades below its issue price, even after the market recovered strongly, doubling from the lows of last year. Seven out of every ten IPOs also failed to deliver the minimum acceptable return of 15 per cent (compounded annual returns) expected from stock market investments.

What explains this dreary picture? The bulk of IPOs have been bunched up in bull markets, which usually encourage ambitious pricing. When market conditions return to “normal”, the stiff valuations fail to hold up.

Indeed, the IPOs priced at par or at a discount to their listed peers are the ones that performed well, while many of the worst hit IPOs were ambitiously priced. The sector profile however, did not have too much of a say in how well an IPO delivered, since both best and worst performers share sector space.

For this analysis, 264 IPOs from January 2000 to January 2008 were considered. Returns were reckoned based on their compounded annual returns from their issue price to closing prices on October 17, after adjusting prices for stock splits, bonus and other corporate action. Here is a detailed picture derived from this analysis.

Between 2006 and January 2008, during the bull run, 166 IPOs were floated, making up more than half the total number of issues over the past nine years. It is these IPOs that have weighed on the overall picture.

The Timing

Reflecting the positive sentiment at the time, these offers appear to have been priced rather aggressively. Consequently, these stocks were hit hard when the market crumbled in the latter half of 2008, and are yet to revert to their offer prices till date.

More than half the IPO stocks from 2006 trade below their issue prices, and 70 per cent of those in 2007 share the same plight. This is in stark contrast to the IPOs in earlier years. About 60 per cent of the crop of IPOs launched in the sedate market of 2005 have generated positive returns.

A good 76 per cent and 88 per cent of those in 2004 and 2003 respectively today trade higher than their issue prices. In fact, of the 20 worst performing IPOs, 18 are from the years 2007 and 2008.

While it can be argued that new businesses may require a few years to pay off, the above experience drives home the point that IPOs in buoyant markets often price in earnings for the first few years, leaving thin margins of safety and room for disappointment.

Pricing issues

Timing apart, investors also need to make sure they don’t pay too steep a price for an IPO, no matter how attractive it appears. Of the top 15 IPOs that did generate positive returns to investors, a good many were priced at valuations on par with comparable peers, or even at a discount to them. Lower valuations therefore left money on the table for long-term investors.

For instance, Divi’s Laboratories had a valuation of just 3.2 times earnings. The stock has returned 76 per cent to date from its issue price. Similarly, Sadbhav Engineering was priced at a valuation of 9 times, when peer HCC was valued at about 27 times earnings.

On the other hand, House of Pearl Fashions (HOPF), 83 per cent of whose issue price was wiped out, was valued at 20 times earnings. This was at a stiff 33 per cent premium over the comparable Gokaldas Exports.

Obviously, an investor can neither decide the timing of an IPO nor its pricing. The question, therefore, is whether at all he should invest in it. If so, what sets a quality IPO apart from a doubtful one?

Going by the compounded annual growth rate (CAGR) in yearly sales and net profits from the offer date to the latest financial year 2008-09, fundamentals did matter in how IPO stocks fared after listing.

Fundamental plays

Therefore, for an IPO to deliver in the long term, the company itself should be in a position to deliver growth in sales as well as profits.

A fundamentally weaker company may not be able to weather a slowdown, as evidenced by the numbers posted by IPOs that have seen substantial price erosion.

For example, while poor performer House of Pearl managed a 51 per cent CAGR in sales, it saw a 29 per cent annual decline in net profits in the years since.

Decolight Ceramics’ sales shrank 10 per cent and profits fell by almost half from its IPO. The stock has dropped 48 per cent from its issue price.

But consider top performer Educomp Solutions, which generated a 160 per cent return. The company clocked 112 per cent sales CAGR and a similar 111 per cent net profit growth. Divi’s Laboratories delivered a 76 per cent return on issue price, backed by a 30 per cent CAGR in sales and a 41 per cent growth in profits.

Investors often select IPOs based on the market fancy at a particular point in time. Software IPOs were all the rage in the late 1990s and realty IPOs in 2007.

Sector irrelevance

But the analysis shows that company fundamentals matter much more than the sector profile in IPO performance.

Neither the IPOs that did well, nor those that performed poorly show a distinct sector bias. In fact, the same sectors feature in both groups.

For example, textile player and retailer Page Industries delivered a 25 per cent return, while Celebrity Fashions trades far below its issue price and has lost 43 per cent for its investors.

Similarly, financial services players Motilal Oswal and Religare Enterprises have held well above issue prices while Future Capital Holdings has fallen 44 per cent annualised.

Takeaways

With the IPO season back in full force now, what are the lessons investors should keep in mind?

One, they should be wary of issues bunched up in a bull market as companies could take advantage of buoyant spirits and set steep prices as well as float quite a few dubious offers.

Two, pricing and valuations should be justified based on performance record and future earnings. But take note of how far into the future earnings potential is being factored into current pricing.

Three, company fundamentals should be reasonably sound; a thorough check should be done before making an investment decision; tabs should be kept on how a company is performing in terms of sales and profit growth even after listing.

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