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Factors to Consider Before Investing in IPO

16 August 20225 mins read by Angel One
Factors to Consider Before Investing in IPO
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After a fairly long lull of over 5 years between 2010 and 2015, IPOs are back in the reckoning over the last couple of years. Apart from quality IPOs like Alkem, Dr. Lal Pathlabs, Interglobe Aviation, Avenue Supermart and Sankara Building Products that performed exceedingly well after their listings, IPOs on an average have performed very well post listing in the last 2 years. Additionally, there has been quality paper hitting the market. After ICICI Pru Life became the first insurance company to get listed through an IPO, both SBI Life and HDFC Life are following closely behind with their IPOs. Additionally, two PSU general insurers viz. GIC RE and New India Assurance are also planning an IPO. While IPOs raised $2 billion in the fiscal year 2016-17, we are likely to see IPOs of nearly $5 billion in the fiscal year 2017-18.

With the massive oversubscriptions seen in the retail and the HNI segments, it is clear that interest in IPOs as an asset class is back with a bang. The big challenge for investors in IPOs is how to evaluate whether an IPO is worth investing or not. Here are 5 key takeaways…

  • Prefer a business with a granular focus; diversified model is passé…

An IPO is just like buying in the secondary market because you are buying the business not the stock. You obviously want the business to be focused rather than a holding company type of business that is dabbling in a lot of unrelated areas. That is exactly what happened to Cafe Coffee Day. It had interests in coffee trading, coffee retailing, financial services etc. The real outperformers were highly focused plays. VRL focused only on logistics, Syngene on research, Interglobe on aviation, D-Mart on retail and Dr. Lal Pathlabs in laboratory testing. Ideally, put your money into IPOs that have focused business models and an established track record. They are more likely to work in your favour.

  • Check out how the company proposes to use the IPO proceeds…

This is a lot more critical than it appears to be. Ask your advisor some serious questions about how the funds are going to be utilized. In the past, there have been umpteen instances of IPOs that were raising funds just because it was available. Similarly, raising an IPO for repaying debt is not a great idea because the cost of equity is higher than the cost of debt. Thirdly, don’t focus on companies that raise IPOs to finance their working capital needs. That is a classic case for a maturity mismatch. You need to put money in IPOs where funds are being raised for expansion, capital allocation or acquisitions that are genuinely likely to improve the ROI in the coming years.

  • Why are the promoters and anchor investors exiting via the IPO?

To be fair, promoters need to monetize part of their holdings at some point of time as do anchor investors. The problem arises when the promoters and anchor investors take a substantial exit through the Offer-For-Sale (OFS). IPO investors count on anchor investors to provide continued guidance to the managements over a longer period of time. A substantial exit by promoters and anchor investors via the OFS does not inspire confidence in the investors and you must approach such IPOs with caution.

  • The real devil lies in the details…

The prospectus is an important document and as an investor you need to go through it in detail. Firstly, check if the IPO is substantially diluting the EPS of the company. A golden rule is to avoid IPOs of companies with a very large capital base. They will always struggle to grow their EPS and create ROI for shareholders. Secondly, be cautious if the projections are too aggressive. You must put money in a prudent business not in a sales pitch. Lastly, do some background checks on the promoter background through Google and the MCA website. In an era of widespread information dissemination, it is not too difficult to do a smart background check of the promoters. That matters a lot!

  • Finally, can the company add value with minimal leverage…?

Firstly, value creation is all about growth. It is one thing if you want to just exit on listing, but it is another thing if you want to hold on to the company. In that case, ensure that the company is in a sector with adequate growth potential. Secondly, we have already spoken about preferring companies with smaller equity. Such companies are better positioned to create value and growth. Lastly, avoid companies that have a huge debt burden hanging around the neck. These are the most vulnerable to industry and macro shocks!

As Peter Lynch rightly said, “Behind every stock there is a company so try to first understand what that company is all about”. That applies to IPOs too!

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