Are IPOs worth it?

The Initial Public Offering (IPO) marks a pivotal moment for private companies transitioning to the public sphere, raising funds from the public for the first time. This shift provides an exit route for private investors and promoters. In the current market scenario, there’s a high level of investor enthusiasm towards IPOs. Some seek listing gains, while others anticipate significant capital returns. The fundamental question emerges: Should we invest in IPOs or not? Let’s delve into this frequently asked query.

IPO as an Exit Route:

IPOs are primarily issued when companies aim to expand for growth prospects, requiring substantial funds beyond traditional financing avenues like banks. However, when IPOs become exit strategies, and existing shareholders profit at the expense of investors, problems arise. IPOs should be advantageous instruments, but when companies prioritize cash generation over investor interests, retail investors often bear the brunt. It’s crucial to scrutinize the intended purpose of an IPO before investing. If it doesn’t align with expectations, it’s advisable to steer clear.

Overvaluation of IPOs:

Many IPOs in the primary market tend to be overvalued, where the IPO value surpasses the company’s actual worth. This overvaluation stems from the expectations of promoters, existing investors, public optimism, and market hype. Even investment gurus like Warren Buffett echo this sentiment, viewing IPOs as overpriced and highlighting that sellers choose when to go public – a time seldom favorable to buyers. Benjamin Franklin, a pioneer of value investing, also discusses how IPOs are often released when people are willing to pay a premium. This leads us to explore why IPOs are frequently issued during market peaks.

Timing of IPO Issuance:

Given the tendency for IPOs to be overvalued, why are investors still willing to pay a premium? The answer lies in the timing – many IPOs are launched during market peaks when optimism is at its zenith. During such periods, people exhibit confirmation bias, disregarding market cycles, convinced that the current time is different. Companies exploit this situation, and it’s observed that the market often faces a decline before a surge in IPO issuances. Sometimes, these poorly performing IPOs exacerbate market downturns.

Investing for Listing Gain:

When considering reasons to avoid IPOs, some argue they are solely for listing gains with no intention of long-term holding. This approach, mainly adopted by traders, can be detrimental to your investment philosophy. Shares capable of providing listing gains are often oversubscribed, but oversubscription doesn’t guarantee positive returns. Investing solely for listing gain involves risks, as oversubscribed shares may yield fewer shares than expected. Additionally, it can lead to a shift from trader to investor, holding incorrect shares against trading strategies. Data from 2015 indicates that out of 52 IPOs, 11 provided negative listing gains, and 10 offered less than a 10 percent return.

Conclusion:

Investing in IPOs may not always be a wise choice, as appearances can be deceiving. While quality IPOs can yield good long-term returns, caution is essential. Considering the outlined points when investing in IPOs may enhance portfolio returns. Adopting a strategy of chasing every IPO is not advisable and could result in negative returns over time.