Aarati Krishnan

Do we really need retail quotas in IPOs?

Aarati Krishnan | Updated on January 09, 2018

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Luring small-time investors to IPOs through quotas is like letting toddlers loose in a game reserve

Stock market experts on television may still insist that what we’re seeing is an orderly bull market, and not a bubble. But primary market action suggests plenty of froth.

Barely three years ago, Initial Public Offers (IPOs) from public sector firms were scrounging for subscriptions from a disinterested public. But subscription numbers for the recent Cochin Shipyard IPO tell us how drastically the situation has changed, with the ₹1,468-crore offer attracting bids worth over ₹1 lakh crore. Other IPOs in recent weeks have attracted an equally frenzied response, with AU Small Finance Bank over-subscribed 53 times, CDSL over-subscribed 170 times and HUDCO bagging bids for 79 times the shares on offer.

There are other signs of hyper-activity in the primary market too. NBFCs are doing brisk business extending short-term finance to punters on IPOs. Grey market premiums are a hotly discussed topic in electronic chatrooms.

Luring first-timers

In India, boom times in the primary market have always been the cue for a new batch of first-time investors to jump into the stock markets. Listing gains often lure such investors to believe that the stock market is a shortcut to riches. Historically, the addition of new demat accounts in India has correlated closely with primary market activity. This is evident in this bull market too. In the last two years, the two leading depositories opened as many as 50 lakh new demat accounts, twice the number in the preceding two years.

But why are retail investors, especially first-timers, so taken with IPOs? Do these newbie companies really deliver bumper gains to all who bag allotment to them? An objective study of the returns delivered by past IPOs suggests that they mostly don’t.

Inexplicable frenzy

The Bombay Stock Exchange disseminates an index called the BSE IPO index, which tracks the performance of all the IPOs listed on it each year. This index includes all companies with a minimum market cap of ₹100 crore as soon as their IPO closes, and tracks their stock prices for a full year thereafter.

This index, which flagged off with a base value of 1000 in May 2004 trades at 4600 today. It has delivered a not-so-exciting annualised return of 12 per cent in the 13-odd years since inception. Instead, an investment in the Sensex30 basket in May 2004 would have earned you a 14 per cent return. Had you started a systematic investment plan in a middling large-cap equity fund in May 2004, it would have earned a 15 per cent annualised return till date.

But the even bigger risk with IPOs, and one that makes them very unsuitable for first-time investors, is their tendency to veer towards extreme outcomes. Number-crunching on the Bloomberg database of 500 IPOs that have hit the Indian market in the last 10 years reveals wide divergence between the best- and the worst-performing ones.

The worst-performing IPO firms of the past decade (there were a dozen) have wiped out 99 per cent of the money invested by their IPO allottees. The best-performing ones are ten-baggers (there were only three of them).

Holding on to IPO stocks for the long term doesn’t automatically create wealth either. In August 2017, despite the stock market trading at new lifetime highs, 48 per cent of the IPO firms of the last decade still languished below their offer prices. Some of the most high-profile IPOs (Reliance Power, Adani Power, Jaypee Infratech and Oil India, to name a few) are also the most prominent on the loss-makers list.

In fact, this tendency of IPOs to reel in unwary retail investors and subject them to systematic wealth destruction, is a global phenomenon. Many legendary investors from Ben Graham to Warren Buffett have admonished investors against betting on IPOs. There’s a solid theoretical basis for their arguments.

In the stock markets, only two key factors contribute to superior investment returns — an investor’s superior insight into a business and a low acquisition price. But the very structure of the primary market makes these two conditions difficult to meet.

Because IPOs require the company’s promoters to open up their financials for the first time to the public, these insiders can be quite selective with their disclosures. And because IPOs always entail the promoters (or private investors) diluting their stake in favour of the public, they are usually timed to raging bull markets and over-priced to maximise the takings for the sellers. As Warren Buffett said, “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 to a less knowledgeable buyer.” Buffett’s warning applies specially to Indian investors today. Many of the current crop of IPOs are the result of private equity investors seeking to offload their stakes in ventures that they have steered for years.

Case against quotas

What these arguments show is that encouraging small-time investors to bet on IPOs through special retail quotas and discounts is like letting toddlers loose in a game reserve. As IPO investing is a game best suited to professional investors, it is for SEBI to rethink its current regulatory framework for IPOs.

Today, the market regulator is clearly caught between the conflicting objectives of trying to develop India’s primary markets by getting more firms to list themselves, and at the same time preventing retail investors from burning their fingers in poor quality offers. It has so far juggled these objectives by allowing only firms meeting certain networth and profitability criteria to tap the markets, requiring book-built offers for others, and setting quotas for institutional and retail investors in book-built offers. Its own vetting process and disclosure requirements for IPOs have also become more and more onerous over the years.

The net result of all this is that very few unlisted firms choose to take the market route in the early stages of their growth and are content to access private investors for capital. And despite all the rigmarole around disclosures, many poor quality issues do slip through the gap and end up hurting retail investors.

Given the circumstances, it would be wiser for SEBI to abandon its efforts to make the primary market a safe place for newbie investors. It should instead do away with the retail investor quota in IPOs in entirety and signal clearly that IPOs make for very risky investments.

Unlike a decade ago, small investors in India today have many professionally managed vehicles to choose from, if they are keen to participate in the wealth-creation potential of equities. Exchange traded funds, actively managed mutual funds and the National Pension System all offer well-designed, risk-controlled vehicles, managed by professional money managers, for small investors to experiment with equities. It is time SEBI nudged them towards these and took a hand in curing them of their irrational IPO fetish.

Published on August 17, 2017

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