Why history tells us to beware the IPO frenzy

“The last car we had was a chocolate brown Skoda Superb that he got second-hand,” said Neil Parikh, son of Parag Parikh and now the chief executive of PPFAS MF. “His thought process was that once you buy a brand new car it depreciates 30% in value the moment you drive out of the showroom.”

In this article, Mint has distilled Parag Parikh’s approach to IPO investing. We have drawn insights from his book ‘Value Investing and Behavioral Finance: Insights into stock market realities’ and snippets from his lecture on IPO investing on PPFAS’s YouTube channel.

Parag Parikh passed away in a car accident in the US in 2016 while going to attend Berkshire Hathway’s annual general meeting.

The lure of the new

Parikh believed investing in IPOs to be one of the worst ways to enter a stock. A company typically issues an IPO to fund an expansion or to allow its investors from earlier to sell their stakes in it. To get the best possible price for its shares, a company would typically want to time its IPO during a bull market. In effect, new investors end up buying its shares at a high price. It’s no surprise why IPOs rarely make an appearance during bear phases, when the stock markets are depressed.

India’s current IPO fad is not a new phenomenon. During previous bull market phases too India’s IPO markets saw heightened interest. In the 1990s, before the internet bubble burst, 74 companies got listed. Nearly 80% of those were tech companies. Only 48% of those companies exist today, Parikh said in his book that was published in 2009.

Similarly, when the frenzy for finance and real estate stocks died in 2008, the share prices of seven out of the 11 real estate companies that had listed between December 2006 and then were 40% below their listing price. The other four stocks were hovering around their issue price.

Among finance stocks, shares of Motilal Oswal Financial Services Ltd and Edelweiss Financial Services Ltd, which got listed at the top of the bull market, crashed below their debut price after having doubled initially. The same story had played out during the 1994-95 post-liberalization bull run.

One IPO that gave investors multi-bagger returns was that of Infosys Ltd. The information technology services giant issued its IPO in 1993, before that bull run, and had a tough time getting subscriptions. This enabled investors in the IPO to get their hands on the Infosys stock at a reasonable valuation.

But during the tech boom, Infosys’s stock was trading at more than 200 times its earnings. “Investors who bought the stock at such high rates are still nursing their wounds,” Parikh said in his book.

Buying on listing day

When a potential blockbuster IPO is oversubscribed multiple times, it becomes difficult for an investor to be allotted shares. But many individual (retail) investors get excited by the hype and buy the stock on listing day.

The assumption is that companies tend to underprice their shares during an IPO, leaving some room for listing-day gains. In a bull market, many companies do make listing-day gains, supporting this narrative.

That might give the illusion that the underwriters of an IPO—investment bankers—underprice the share issue for the benefit of new investors. “But such things do not happen in finance, and that too in bull markets,” Parikh said in his book on behavourial finance. Investment bankers typically get a commission as a percentage of the sale, so their incentive is directly tied to how much money they can raise in an IPO.

If a stock gains on listing day, it’s usually not because the company’s promoters left room for new investors to make money but because investors fear missing out on making a killing at the stock markets.

Another way to think about this is that promoters seek handsome returns based on the IPO price band. A further increase in the share price on listing means new investors are paying more than what the promoters considered a fancy price.

Of the 3,122 IPOs issued between 1991 and 2000, only 1,540 continued to be listed on Indian stock exchanges in 2006. The others were merged, delisted, or simply vanished. Of the remaining 1,540 stocks, 56% gave negative long-term results (1991 to 2000) and just 15% managed to beat the Sensex’s returns.

Selling on listing

Reliance Power Ltd listed on the bourses on 11 February 2008. Such was the euphoria around its IPO that the issue was priced at 5,000 times the company’s earnings. New investors were aware of the high valuation but had hoped to make gains by selling the stock on listing day. The problem was that most of the investors who were allotted the stock had the same idea. On listing day, the stock plunged.

“Everyone was buying because everyone else was buying and everyone was thinking that he’s going to be the first one to sell on listing and make a profit,” Parikh said in a video titled ‘Psychology of IPO investing’.

“Most people invest for listing gains. Although we call it investing, it’s actually trading.”

The Winner’s Curse

In a bull market, several IPOs tend to get oversubscribed and list at a pop. The ‘recency and herd instincts’ take over and uninformed investors start applying for every IPO hoping for listing day gains.

But what happens when an overpriced, not-so-good issue comes along? The informed investor stays away, but the lay investor doesn’t and might be allotted the shares of a not-so-good company given the lower demand for its stock—the winner’s curse.

“They get all the shares they want of the poor issues, and they get a small allocation of the good issues,” Parikh said in his 2009 book.