Why invest in IPOs

• Benefits of IPO investing
• IPO success stories: Strike gold
• IPO failures: All that glitters is not gold
• What should you look at before investing in IPOs

Do you recall Cuba Gooding Jr’s pop-culture defining phone conversation with Tom Cruise in ‘Jerry Maguire’? The one where Cruise has to do a “Show me the money!” lung-buster to convince his client Gooding Jr. to stay loyal to him.

You may have been thinking the same when you were reading the previous chapter on how initial public offerings (IPOs) benefit companies.

Fret no more because the answer is unveiled here.

The more you scroll down, the more you’d understand how investing in IPOs can boost your portfolio, how your wealth can increase if due diligence is done.

So, let’s first understand how IPOs can indeed show you the money!

Benefits of IPO investing

#1: Get in on the action early

By investing in an IPO, you can enter the ‘ground floor’ of a company with a high growth potential. An IPO may be your window to rapid profit in a short time period. It may also help grow your wealth in the long run. 

Suppose, you invest in a young company that sells disruptive technology. If it manages to sway the market and rake in profits, you would gain from its success too.

#2: Meet long-term goals

IPO investments are equity investments. So, they have the potential to bring in big returns in the long term. The corpus earned can help you to fulfil long-term financial goals like retirement or buying a house.

Besides, the Indian IPO market is growing. In 2017, the Indian stock market generated almost $11 billion through IPOs^[1].

#3: More price transparency

The price per security issued is clearly mentioned in the IPO order document. So, you have access to the same information as bigger investors.

This would change in the post-IPO scenario. The share prices after the IPO would depend on changing market rates and the best price that the stockbroker can offer.

(Watch video: How to evaluate IPO pricing)

#4: Buy cheap, earn big

The IPO price is often the cheapest price if you invest in a small company that has the potential to grow big. That is because the company may offer a discounted rate. If you miss the IPO window, investing in that promising company may be difficult because the stock price may skyrocket.

You don’t believe it? Let’s taken Amazon’s example. When Amazon.com Inc. floated an IPO in 1997, each share was priced at $18. Had you invested $5,000 in Amazon’s IPO, your shares would have been worth $2.5 million in April 2018^[2].

These stories of riches don’t end with Amazon. Let’s look at some of the jaw-dropping success stories, all thanks to the IPO.

A legend’s regret

Some IPOs go down in history, leaving even legends to regret giving it a miss.

Warren Buffett, arguably the greatest investor of recent times, is one such investor. Buffet never invests in IPOs and is sceptical of tech companies. So, when Jeff Bezos floated the Amazon IPO in 1997, Buffet let the offer pass. At the time, Amazon was an upcoming online retailer dealing mostly in books.

Many other investors turned out to be wiser than Buffett — at least in this particular case.

The IPO’s success made Bezos, the owner of Amazon, richer than Buffett for a brief period in terms of net worth.

But to give Buffett credit, he has admitted his faux pas.

Success amid crisis

Visa International floated its IPO in 2008. The market was turbulent at the time, for the recession was in full swing. Yet, despite the condition of the financial markets, the IPO did not disappoint.

Visa mopped up $17.9 billion from the market. At the close of its first day on the market, the Visa International stock was trading at $44. The next day, the closing price had risen to $66 — a cool 50% jump in one day and that too when the times were tough!

The Chinese century

In 2006, the Industrial and Commercial Bank of China went public. It raised $19.1 billion through the IPO.

The bank issued a staggering 48.39 billion shares at the very low price of 39 cents per share. They chose this approach rather than sell a smaller number of shares at a higher price.

The demand for future contracts—that is, agreements to buy or sell stock at a later date—for the shares exceeded $500 billion! This would have made it twice as valuable as Citigroup, the largest bank in the world at the time.

A real estate saga

DLF (formerly DLF Universal) floated its IPO in 2007. The benchmark indexes in India at the time were heading toward an unprecedented high.

The IPO garnered more than Rs 9,000 crore for the company. On the day of listing on the stock exchange, the stock price jumped by 35% — a lucrative deal for people who invested in this IPO.

The story continues

India has become a global hotspot for IPOs.

Global investors are also eying India for good reason. Some of the IPOs that listed recently are yielding triple-digit annualised profit.

For example, consider the case of Macpower CNC Machines Limited. Since listing on 22 March 2018, the company is churning out an annualized profit of 359.12%. With an offer price of Rs 140 and a listing price of Rs 149, the stock was trading above Rs 250 at the closing of the market last week.

Another success was Mahickra Chemicals Limited. It posted an even stronger performance with an annualized return of 773.49% over a period of 47 days.

The takeaway

IPOs offer some of the biggest opportunities to create wealth. Some emerging players can change the ballgame forever. Once you spot a winner, take a backseat and enjoy the gains on your investment.

But remember, not all IPOs do well. They can sink without a trace too.

Why do some IPOs fail?

Promoters’ greed

During an IPO, the promoters sell off their shares to the public. The idea is to make as much money as possible. There could be venture capitalists who had invested in the company in its initial days. They would like to exit the venture by making hefty profits and then investing in some other business. Sometimes, this greed could spoil the IPO’s chance of success.

(Read more: How underwriters sell their shares)

Questionable fundamentals

In the case of Reliance Power, the company wanted to raise money to fund five new power projects. It was not about expanding the business. At the time, it had no operational business at all. If a company floats an IPO without being honest about its fundamentals, there is a high chance of failure.

(Read more: Why companies need capital)

Market timing

The share pricing for Reliance Power was too high, ensuring that the promoters made enough for themselves.  Unfortunately for investors, the listing happened when global markets were beginning to slow down. The company cannot solely be held responsible for it, but timing does play a major role in an IPO’s success.

(Read more: Why companies care about stock price)

Valuation

The companies themselves are the best judges for determining their valuation. During an IPO, the company’s top brass discusses the valuation with investment bankers. If the valuation is not fair, retail and institutional investors will bear the maximum risk. This is why so many stocks trade way below the issue price even when the markets are bullish.

X factor

Café Coffee Day, Monte Carlo, UFO Movies, and Adlabs also faced IPO failures. Interestingly, none of these is an unsound company and it is not that their valuations were erratic. The credentials of the promoters were quite well established and there was no dearth of reputation or hype. Yet, something somewhere did not click. That is part of the inherent uncertainty of the stock market.

The bottomline is that just as there is no sure-shot way for an IPO to succeed, there is no guarantee that an IPO will not fail.

So, what should you watch out for while deciding on an IPO investment?

• Risk factor

  No investment is free of risk. Even your fixed deposit in a public sector bank is not absolutely safe. So, if you are investing in an IPO, be prepared to deal with some degree of risk. Keep in mind that the company floating an IPO has so far been privately owned. It may have a potential for growth, but that is no guarantee of future success in the sector within which it operates.

• Risk appetite

  How much risk can you take? If your initial answer is very little, think again. Assess your financial situation, your liabilities, age, and other concerns. This will help you decide how much risk you can afford to take.

  Tip: One approach is to follow this thumb rule: Subtract your age from 100. The number you get is the percentage of your investments that should go into equity. Keep your investment in IPOs within this limit.

• Reason for raising funds
  Every investment bank publishes a prospectus for the IPO being floated. Go through the prospectus with care. The prospectus will mention why the company is raising funds. If it is for expansion, that is good news. If it is for paying off debt or purchasing shares from the owners, be careful. It could be risky to invest in such company. If a company cannot pay its debt without raising funds from the public, it may not do well in future, too.
• Hard-selling by brokers

  An IPO almost never comes directly to retail investors. If it is freely available, it probably means that the institutional investors who were initially approached by the investment bank passed on the opportunity. Take it as an indication of the company's financial health and prospects.

• Available information
  It is difficult to get much information about a company that is yet to be listed. So, it may be a bit tricky to find out exactly where a particular company stands. Although the company’s IPO prospectus gives out details about its assets, liabilities, overall financial situation, and growth prospects, you should look for reports and analysis by third parties in newspapers, magazines, journals, and online. Keep searching to find out details that the prospectus would never tell you.
• Lock-up period

  Find out about the lock-up period, if any. Existing investors in the company may not be able to sell their shares before the mandatory lock-up period ends. So, it may be difficult for you to gauge whether the stock these investors hold has as much value for them as the IPO price. It could be that once the lock-up period ends, these investors would dump their shares in the market. This may cause the price to plummet. So, it may be wise to put off investing in the company till the lock-up period is over.

• The initial excitement

  The Facebook IPO is an interesting case in point. In 2012, Facebook announced its IPO with much pomp. The price shot up significantly right after the market opened. But the initial excitement did not last long. The stock traded just above the IPO price at the closing of the first day. And the stock value fell for nine of the next 13 days. So, it may be wise to let the market settle before reaching for your wallet.

  (Read more: Can an IPO fail?)

• Small is tricky
  Small companies often churn out fantastic returns. But such companies can also go bust. So, extra caution is advisable when investing in a small company.

  
  (Read more: Charts and metrics to track when evaluating an IPO)

Quick recap

• IPOs don’t just help private businesses. They can help your investment grow too. In fact, IPOs can be a great way to make quick profits as well as earn over the long-term.
• IPOs have woven a tapestry of riches tales in the last few years alone, ranging from Amazon to General Motors and DLF back home.
• But there’s a cautionary tale too. Not all IPOs strike gold. So, be cautious, do your research and avoid getting caught in the IPO frenzy. The world of IPOs can be exciting, much like driving a supercar. But you need to know to pull the brakes and control the steering wheel.

What next?

Did you know there are different types of IPOs? Did you know the difference between fixed price and book building, online and online bidding? The next chapter <Things to know before applying for IPO> answers these questions.