Initial Public Offerings or IPOs have been a hot subject lately, especially over the last year.
A number of familiar names have listed in India 2021 - including the beauty and fashion e-tailer Nykaa, the food delivery app Zomato, and the payments fintech PayTM.
We saw a huge demand for some of these stocks when they were listed, but have a mixed bag on the returns - with some like Nykaa practically doubling in price within a few days of listing, while PayTM shedding billions in market cap after listing.
Does investing in IPOs really help you build wealth? Can we make 'multibagger' returns with IPOs?
We try to answer these questions and more through this article.
And we start by looking at the data.
IPOs over the last 15 years
Over the last 15 years (from 2008 through 2021), over 450 companies have been listed with over Rs. 4.3 Lakh Crore (~$57 Bn) of capital raised.
As you can see, in 2021 alone over 60 companies raised funds of INR 1.2 lakh Crore (~$ 16 Bn), making it by far the highest capital raised in a single year. It constituted ~30% of the total funds raised in the last 15 years. We had listings from both - the new-age brands brands such as Paisa Bazaar, PayTM, and Car Trade, as well as the more traditional businesses such as Sona BLW (Auto-Components), Indigo Paints and Star Health (Insurance).
You will also notice that there has been a huge increase in the number of IPOs in issue size in 2007, 2010, 2017 and 2021. If you superimpose the Sensex returns (shown in the chart below) with this, you will see the pattern - in the years the market does well more companies get listed (with 2014 being the exception). IPOs are more correlated with bullishness in the market, rather than with the need for funds.
And where are these funds going? About 60% of the funds are going to promoters and existing shareholders in the Offer For Sale (OFS) part of the IPO, with only ~40% being infused into the company. And the trend has largely been towards an increasing share of OFS.
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How have IPOs performed vis-a-vis the Sensex? An aggregated view
If you had invested equal amounts (let's say INR 100 or $1.5) in each of these IPOs over the last 15 years - Lets call this the "IPO Portfolio" and another investment of an equivalent amount in the Sensex on the exact same days - the "Sensex Portfolio" - how would they compare? Which one would beat the other?
The answer is - that it's pretty much a tie! In either case, the absolute returns would be between 155% - 160%, and an IRR of 10%.
However, this one aggregated number hides a lot of information - so let's break it down further and get some insights from it.
In the following chat we look at the year-wise break-up, and subsequently look at the spread across different IPOs.
The dark blue bars indicate the annualized returns from IPO investments and the light blue ones from Sensex investments in any given year. You will notice a few patterns here too (you can interact with the charts by hovering your mouse / clicking on them):
Sensex returns have been consistent at ~10-15%, with maximum variability in near term - as you would expect (returns average out over longer periods of time)
IPO investments, however, are much more volatile, varying between -2% and 86%
As the timeframe increases, on average Sensex gives higher returns as compared to IPOs in the corresponding year (e.g., in the 10 years between 2007 and 2016, Sensex has beaten aggregate annual IPO returns 7 out of the 10 times)
What might be happening here?
The explanation is that there is generally a high degree of outperformance in some IPOs in the short run, and this moderates over time. In others, there is more clarity on the company being a dud, after consistent non-performance over time, and begins to underperform significantly. Hence, when the timeframe increases, the overall performance of IPOs vis-a-vis Sensex starts diminishing.
The devil in the details - A distribution of returns across the 450+ IPOs
The above analysis was based on an assumption where one would invest equal amounts in ALL IPOs. While it has helped us takeaway some interesting insights, it may not reflect reality where we may not get into all IPOs either because we are selective or because of dumb luck where we do not get an allocation despite applying. Hence, it makes sense to look at the spread of returns across these IPOs rather than the aggregate 10% IRR which we saw.
The chart below shows the the percentage of IPOs across different return ranges (e.g., Less than -80%, between -60% and -80% all the way up to Greater than 100%) and compares it with the distribution of returns of corresponding Sensex investments. So, had you invested the same amount of money on the same day in an IPO vs. Sensex, what range of returns the IPO investments would have given vs. range of returns you would have ended up with by investing in Sensex - is what the chart compares. As before, the dark blue bars correspond to IPOs.
Following are some of the inferences we can make from this analysis:
About 10% of the IPOs give a return worse than an 80% loss, while the worst performance of any of the investments in the Sensex is in the -40% to -20% bucket, which is also only 1% of the times. This is because ~45 of the 450+ companies which got listed have completely eroded their equity value, and most of them are delisted now as well.
53% of all IPOs have given negative returns (a sum of all the dark blue bars from <-80% to 0%), implying that over half the IPOs have led to losses. On the contrary, the corresponding Sensex investments have given negative returns only 7% of the time - which tends to 0% as we increase the time horizon.
~70% of all IPOs have given below average returns of 10% (sum of all the highlighted dark blue bars), while only 13% IPO investments have hit it out of the park with IRR over 40%, as compared to 32% of the investments in the Sensex returning over 40%. Essentially, this means that most IPOs are sub par investments giving you below average returns, while there are just a handful of them which give exceptional returns, bringing the average up. In reality, we need to be extremely skillful or extremely lucky to catch hold of these IPOs which are the future Infosys, HDFC Bank, Eicher Motors and invest in them.
While I can't say much about luck, getting the right IPO with skill is difficult to say the least.
Now that we have a perspective on the data, lets now look at the narrative and biases that come along.
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A case against IPOs
The system is rigged in favor of IPO sellers
An IPO is the means though which companies raise funds from the public - usually for expansion or for parking debt - whereby the company gets listed on an exchange. They are a necessity for the stock market to exist and thrive.
However, as we discussed above, it is simultaneously a means of giving an exit to existing investors through OFS too. The company and its investors hire expert sell side advisors - the Investment Bankers who assist with the listing process, help with the valuation and bring in the institutional investors to anchor the IPO and bring validity to the price.
The existing investors who are selling their stake to us, the public, have a complete understanding about the company’s operations including what will not be in the public domain, know the management thoroughly, and have all the incentives and the means to maximize their own value . They will do everything in their power to keep the price as high as possible, with the ceiling being set by their perception of what will just about ensure full subscription.
On the other hand, the public (retail) investors are sold the future potential of the company - especially with the new age businesses currently bleeding money and without too much history. They don't stand a chance in most cases, and it only gets worse in an exuberant market like the one we had last year. As Warren Buffett said it in his 2004 shareholder meeting:
"An IPO situation more closely approximates a negotiated deal. I mean, the seller decides when to come to market in most cases. And they don't pick a time necessarily that's good for you.... It is more of a negotiated sale. And negotiated transactions are very hard to get bargains. If you take the houses in Omaha, you know, somebody that lives next door to somebody who sold their house for $80,000...and their house is more or less comparable, they're not going to sell it for $50,000. It just doesn't happen... That's what happens in negotiated sales.”
And as Ben Graham put it in his investing masterpiece - The Intelligent Investor:
"Weighing the evidence objectively, the intelligent investor should conclude that IPO does not stand only for “initial public offering.” More accurately, it is also shorthand for: It’s Probably Overpriced, Imaginary Profits Only, Insiders’ Private Opportunity, or Idiotic, Preposterous, and Outrageous"
Picking the right IPO is tedious, boring and time consuming
Picking the right stocks from the secondary market, which have been listed for several years is a difficult proposition. It involves the effort of understanding the business, reading Annual Reports over several years, reviewing investor call transcripts, doing scuttlebutt with key players and more. It is a lot of effort, but in today’s day and age, at least availability of information is not the challenge. It is actually the will to put in the effort to do all of this analysis which is the challenge. Arguably, only some investors have been able to consistently generate returns better than the overall market (outside of Twitter of course), and they have usually spent a lifetime putting in the effort to analyze businesses and sectors.
Now imagine trying to do this with a company with no history, sometimes in an industry which is just emerging, with a strong narrative being pushed by the management and the sell-side bankers. It becomes several times more difficult.
Yes, the regulator (SEBI in India) has out in place disclosure requirements and any company listing in India should disclose details about its operations, business model, industry, financials in a document called the DRHP - the Draft Red Herring Prospectus. A tedious 400-500 page document published by companies looking to be IPO’d. How many of us have read a DRHP? And yet, how many of us have invested in IPOs?
In most cases, our base case is ‘Hope’ when it comes to IPO investing.
Survivorship Bias laden narratives makes them deceptively attractive
Most of us have been presented with an analysis of how INR 10,000 ($ 140) in the Infosys IPO in 1993 would be worth over INR 20 Crore (~$ 2.7 MN) today - for the ones who have missed it (fortunately?), the analysis is shown below.
We have been told how we missed the bus by not investing in the IPOs of HDFC Bank, Reliance Industries, Kotak Mahindra Bank and the likes. And how the upcoming IPO(s) will provide us with such opportunities, should we catch 'em young at cheap valuations before the larger investors ‘discover’ them.
Unfortunately, such stories are laden with survivorship bias - where we make inferences only based on looking at the survivors (such as Infosys) and ignore the scores of companies which were also market darlings around the 2000 tech bubble - which went bust. A person invested in DSQ Software (or hundreds of other companies) in 1999 would have thought it was a no-brainer investment, only to lose ~100% value subsequently.
As can be seen from our analysis, only a small percentage of IPOs (or most things in life actually) generate exceptional returns - the tails. And tails are difficult to predict.
The lure of the listing gains
Then there are others who like to play the listing gains strategy - where they take cues from the grey market premia (GMP) of the stocks, on potential gains upon listing. Some would even leverage up 10x to get a share of the HNI category which often gets subscribed several times over the allotted amount. The idea is to get an allocation with borrowed funds (if the subscription is 10x of the available # of shares, the allocation in HNI quota would be 10% of the subscribed amount), return the unallocated borrowed amount, recover the interest and make handsome gains on your capital.
While it all sounds good, there are just 2 problems. First, we really don't know (and can never know) if the listing gain will be there. At the end of the day we would still be speculating if we bought IPOs for listing gains. Second, we are just greedy primates, controlled by our biases. Even i we make listing gains, most of us would not have the discipline to stick to the thesis of the speculation (yes speculation, not investment) and hope for more. We would warp reality to fit our greed based narrative that the price has gone up because this business is going to __________ (fill in whatever story you fancy here). And eventually hold it until it falls. This has happened time and again with a large number of investors, with the most recent instance being that of the 2021 blockbuster IPO investors - now sitting with valuations below IPO price.
PS: SEBI has put in new restrictions IPO funding effective 1st April 2022, which limits the extent of IPO finding to INR 1 Crore. A positive step to reduce the distortion in demand for IPOs, especially in the HNI category.
Conclusion
IPOs have always generated keen interest and a lot of noise from investors, especially in times of Euphoria. While there have been some blockbuster IPOs, which have generated tremendous amount of investor wealth, they have been few and far between - like really few and really far.
On average IPO investments have not done any better than corresponding investments in the Sensex. However, at an individual level most (70%) have performed much worse than the average, with over half of them leading to losses and ~10% completely wiping out your capital.
There are a few reasons why IPOs may not be the right investments. For one, the sellers are at a huge advantage as they decide when to launch the IPO and what to price it at. Further, it is really difficult to pick the rare winners simply because there is not too much history of performance, governance standards, and sometimes even the industry the company is in. Nevertheless, the narrative laden with Survivorship Bias leads us to invest in IPOs, hoping for the next Infosys, Tesla or Amazon.
But hey, IPOs are fun. You get to invest in new and upcoming stories, emerging sectors and promising founders. And honestly, if people didn't invest in IPOs, the stock market as we know today,, wouldn't exist. The point of this article is not to scare you off IPOs, rather to give you the facts and prepare you on some of the pitfalls. If you really believe a company listing on the bourses has tremendous potential and is valued fairly, by all means do invest - but just don't bet your house on it.
What's your take on IPOs? And which IPOs have generated wealth for you? Let’s hear about it in the comments.
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Note: A special thanks to https://www.chittorgarh.com/ , from which most of the data is sourced. Do note that given this is a free resource, there has been some cleaning up of the data required and the numbers may not be perfect. The takeaways wouldn't change though. As Buffett says - It's better to be approximately right, than be precisely wrong
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