Should retail investors invest in IPOs?

VK Vijayakumar

The IPO market in India is buzzing again. Some recent issues have been highly successful and investors in these issues have earned handsome returns. At the same time, some famous names have done poorly and investors lost out since the issues were listed at huge discount to the issue price. This raises the important question: “Should retail investors invest in IPOs?”

Every economy needs a vibrant IPO market. Capital mobilisation for investment happens through IPOs. When the capital market functions effectively, resources get channelised into the most productive uses.

Do homework and go by accepted norms

When a good management with a proven track record comes out with an IPO, the market responds positively and capital mobilisation happens.

On the other hand, if the projects are not sound and if the management lacks credibility, the issue fails. This market mechanism ensures that resources go into the most efficient uses.

However, things are not easy in practice. It would be very difficult to anticipate the performance of a new breed of entrepreneurs operating in a sunrise industry. The Infosys IPO of 1994, which gave investors incredible returns, was hugely under-subscribed. It is also possible that a new project by an established group may fail. This makes investing in an IPO problematic. However, retail investors can invest in IPOs successfully, if they do some homework and go by some accepted norms.

The success story of the Indian stock market began with the FERA dilution of the 1970s. The MNCs coming under the FERA (Foreign Exchange Regulation Act) were then known as FERA companies. These companies were forced by the government to dilute their equity by issuing shares to the Indian public. Companies like Colgate, HUL etc. diluted their equity by offering shares to the Indian public. Since the issue price was determined by the CCI (Controller of Capital Issues), the price was artificially low. Investors in these stocks, within few years, received incredible returns from these investments. This was the beginning of the boom in the Indian stock market. The IPO frenzy of the 1980s led to a large number of low-quality issues. Many ‘fly-by-night’ operators made IPOs and took investors for a ride. Gullible retail investors who applied for these issues lost heavily. The poor regulatory environment of those times facilitated this fraud on investors. This practice of cheating the retail investors by the promoter-investment banker racket continued even in recent times.

Learning from experience, market regulator SEBI introduced some safeguards, such as the following, to protect the retail investors in the IPO market:

• Sure-shot allotment, subject to availability. (Earlier investors applying at the upper price band were allotted shares proportionately). This resulted in retail investors not getting allotment, in case of huge oversubscription.
• Minimum application size increased from Rs 5,000-7,000 to Rs 10,000-15,000.
• Low-cost demat account with nil annual maintenance charges. (Maximum value of securities held should not exceed Rs 50,000).
• User-friendly application mode. Investors can apply electronically through brokers.
• Non-retail investors not allowed to withdraw or downsize bids. (Non-retail investors used to apply in huge quantity, creating an impression of over subscription and huge interest in the stock, and later downsize or withdraw their bids).

Threat to retail investors

While these steps are welcome, these alone cannot protect the retail investor from the pitfalls of the IPO market. The real threat to retail investors comes from the mispricing of IPOs when greedy promoters in connivance with investment bankers charge excessive premium for IPOs. There had been many instances of over-pricing of IPOs taking investors for a ride.

Be choosy and discrete

The message is clear: Investors should apply for IPOs, but they should be choosy and discrete. Reasonably priced IPOs of good quality should be lapped up and highly priced IPOs of yet-to-be-proven businesses should be avoided.

The difficult part is in identifying what is ‘reasonable price’?

Going by financial parameters alone may not be prudent. Sentiments and expectations play an important role in determining the market price. Market always discounts the future. Retail investors may not have the expertise to look at and analyse all relevant information.  Therefore, they can look at some indirect pointers.

For instance, institutional demand can be an important indicator of the quality and acceptability of the issue. There can be exceptions to this rule also. Formerly, large players used to put in huge orders creating an impression of substantial interest in the stock and the possibility of over subscription. This used to mislead retail investors into applying for the IPOs. Now that the SEBI has disallowed withdrawal or downsizing of IPO application by non-retailers, this danger is not there. The track record of the promoters and the nature of the industry are important.

Don’t take risk with unknown promoters

Investors should not take risk with unknown promoters even though some of them will do well subsequently. Similarly, it would be prudent to avoid IPOs in companies operating in highly competitive industries with low-profit margins. Promoters and investment bankers also have a role. Promoters should price the issue in such a way that it leaves something on the table for investors. 

Therefore, it would be imperative that all market participants — promoters, investment bankers, institutional investors and retail investors — play the game according to the healthy rules being laid out by the market regulator. If this happens, we will have a vibrant IPO market and everyone, including retail investors, will benefit. The benefit to the economy and the country at large would be substantial.

The author is Investment Strategist, Geojit BNP Paribas. The views expressed in this article are his own