Why History Teaches Us to Beware of IPO Madness

“The last car we had was a chocolate-brown Skoda Superb that he bought second-hand,” says Neil Parikh, Parag Parikh’s son and now CEO of PPFAS MF. “His thinking was that if you buy a brand new car, its value drops by 30 per cent the moment you drive it out of the showroom.”

In this article, Mint extracted Parag Parikh’s approach to IPO investing. We have drawn conclusions from his book ‘Value Investing and Behavioral Finance: Insights into the Realities of the Stock Marketand excerpts from his lecture on IPO investing on the PPFAS YouTube channel.

Parag Parikh died in a car accident in the US in 2016, on his way to the Berkshire Hathway annual general meeting.

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The temptation of novelty

Parikh considered investing in IPOs to be one of the worst ways to go public. A company typically issues an IPO to fund expansion or to allow its previous investors to sell their shares. In order to get the best possible price for its shares, a company usually wants to schedule an IPO during a bull market. As a result, new investors end up buying shares at a high price. It’s no wonder that IPOs rarely appear during bear markets, when stock markets are down.

The current IPO craze in India is not a new phenomenon. In previous booms, too, Indian IPO markets have seen increased interest. In the 1990s, before the dot-com bubble burst, there were 74 listed companies. Almost 80% of them were technology companies. Only 48% of them exist today, Parikh said in his 2009 book.

Similarly, when the financial and real estate stock boom died down in 2008, the share prices of seven of the 11 real estate companies that were listed between December 2006 and then were 40% below their listing price. The remaining four stocks hovered around their issue price.

Among financial stocks, shares of Motilal Oswal Financial Services Ltd and Edelweiss Financial Services Ltd, which were at the top of the bull market, fell below their debut prices after initially doubling. The same story had been played out during the post-liberalisation bull market of 1994-95.

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One IPO that brought investors multibagger returns was Infosys Ltd. The IT services giant had launched its IPO in 1993, before this rally, and had struggled to get subscriptions. This enabled IPO investors to pick up Infosys shares at a reasonable valuation.

But during the tech boom, Infosys shares traded at more than 200 times earnings. “Investors who bought the stock at those high prices are still nursing their wounds,” Parikh said in his book.

Purchase on the day of issue

When a potential IPO is oversubscribed many times over, it is difficult for an investor to get an allotment of shares. However, many individual (retail) investors get excited by the media hype and buy shares on the listing day.

The premise is that companies tend to underprice their shares during IPOs, leaving some room for profits on the day of listing. In a bull market, many companies make profits on the day of listing, supporting this narrative.

That can create the illusion that the IPO underwriters—the investment bankers—are underselling the stock to benefit new investors. “But that kind of thing doesn’t happen in finance, much less in bull markets,” Parikh said in his book on behavioral finance. Investment bankers typically get a commission as a percentage of sales, so their incentive is directly tied to how much money they can raise in an IPO.

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If the stock gains on the day of listing, it usually does not mean that the founders of the company left new investors a chance to earn money, but that investors are afraid that they will lose the opportunity to make big money on the stock market.

Another way to think about it is that promoters are looking for attractive returns based on the IPO price range. Further appreciation in the share price upon listing means that new investors are paying more than the promoters thought was an attractive price.

Of the 3,122 IPOs issued between 1991 and 2000, only 1,540 were still listed on Indian exchanges in 2006. The rest were merged, delisted or simply disappeared. Of the remaining 1,540 stocks, 56% had negative long-term performance (1991-2000), and only 15% managed to beat the Sensex returns.

List sales

Reliance Power Ltd made its debut on the stock exchange on February 11, 2008. The euphoria surrounding the IPO was so great that the stock was priced at 5,000 times the company’s earnings. New investors were aware of the high valuation but were hoping to make a profit by selling the stock on the listing day. The problem was that most of the investors who were allotted the stock had the same idea. The stock fell sharply on the listing day.

“Everybody was buying because everybody else was buying, and everybody thought he would be the first one to sell on the list and make money,” Parikh said in a video titled “The Psychology of IPO Investing.”

“Most people invest for the price gains. Although we call it investing, it is really trading.”

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The Winner’s Curse

In a bull market, a few IPOs tend to get oversubscribed and quote in the pop. “Recency and herd instinct” take over and unwitting investors start applying for each IPO, hoping for the profits on the listing day.

But what happens when an overvalued, not-so-good issue comes along? The seasoned investor stays away, but the average investor doesn’t and may end up with shares of a not-so-good company given the lower demand for its shares—the winner’s curse.

“They get as many shares as they want from the poor issues and a small share of the good issues,” Parikh said in his 2009 book.