IPO markets are hot; may cooler heads prevail

Photo: iStock
Photo: iStock

Summary

The evidence is overwhelming that IPO boom phases are exactly when investors should beware risks

From the ecstatic highs of Nykaa to the despondent depths of Paytm, Indian flippers of initial public offerings (IPOs) have been on a roller-coaster ride through the crowded IPO amusement park squatting on Dalal Street for the past few months. With merchant bankers and brokers acting as purveyors of the “finest" companies India has to offer, throngs of investors have flocked to the fair grounds to roll the dice for a game of IPO flipping. What most investors seem to be missing in their liquidity-sozzled sojourn at the IPO casino is a sober understanding of the economics of IPOs and their post-listing performance. The near mythical devotion of investors to IPOs and frenzied adulation that greets the entry of some firms to our public markets for their “unique" and “disruptive" business models beg the following question: How have IPOs performed historically?

Academic studies offer overwhelming evidence that IPOs tend to cluster in time and by industry. These “hot" and “cold" cycles prompt the question of whether firms really need capital all at the same time. Studies have shown that the “clustering of investment" hypothesis as an explanation for IPO market cycles is weak. Most IPO firms do not have urgent funding needs, and companies that enter the market to raise money during “hot" and “cold" periods do not seem to differ in their growth prospects or future operating performance. Most importantly, there is considerable evidence to support the view that IPO decisions are driven by market-timing attempts by managers. This is compounded further by an information asymmetry that underlies IPO usage, with better-informed insiders and early backers often looking to offload their stakes upon less informed public market investors.

The evidence from the long-run performance of IPO stocks is even more compelling. According to data compiled by Loughran and Ritter, the average first-day return on IPOs in the US was 17.9%, while the market-adjusted 3-year buy-and-hold return was a shocking negative 15.8%. Companies that go public in years with high IPO volumes (or in “hot" markets) tend to underperform other IPOs. A study by Nasdaq shows that 64% of IPO firms underperform the market by more than 10% three years after listing. Qualitatively similar results apply to Indian markets.

Avid connoisseurs of IPOs may now aver that the long-run underperformance of IPOs is on account of the vagaries of an unpredictable market and not due to deficiencies in the business models of these companies. This is possible, but unlikely. Jain and Kini find that there is a significant decline in the operating performance of IPO firms after listing, suggesting that market underperformance is driven by business weakness and not by an emotionally fickle Mr Market. Some debutants also use accounting tricks such as reducing their marketing expenditure sharply just before an IPO to show higher profitability and give a cosmetic makeover to a business model that may get exposed once the listing euphoria subsides.

Indian markets have a rich repository of IPO anecdotes. India has seen three major IPO cycles—in 2007, 2010 and now 2021. During the 2007 cycle, education stocks like Educomp and Everonn had attracted the fancy of IPO investors, who showered them with listing gains of 123% and 241% respectively. Educomp currently trades at less than a tenth of its listing price, while Everonn has been delisted. Similarly, in the 2010 cycle, the largest listing gains were made by Careerpoint Infosystems (103%), which now trades at half its issue price. On the other hand, IPOs that tank on listing day can be phenomenally profitable in the long run. The biggest wealth creators of the 2007 IPO cycle have been Astral Poly and Page Industries, which are up 20 times and 10 times respectively since listing. Both these IPOs had tanked on listing day: Astral Poly by 10% and Page by 21%.

Internationally, Google had to drastically cut its offer price pre-IPO, and despite its listing ‘pop’, its offering was widely seen as a failure. Facebook had no listing pop and its stock plummeted to less than half its offer price in a few days after its listing. These anecdotes reinforce the view that IPO listing returns are fickle and reveal little about the quality of the business.

While there is little doubt about the eventual underperformance of most IPOs, trigger- happy traders can contend that IPOs are ideal for harvesting listing gains, which seem to be plentiful in this market. My analysis, however, shows that the quest for listing gains is riddled with risk. In 2021, the average IPO listing day return was 26.4%. This number seems impressive till it is juxtaposed with the standard deviation of these returns (which signals risk)—a massive 41.5%. For an IPO trader trying to harvest listing gains, these numbers imply a Sharpe ratio of 0.49, which is far lower than that of an average exchange-traded fund tracking the NSE Nifty. Not only do listing gains come with disproportionate risk, a harvesting strategy requires huge leverage to muscle through oversubscribed allocations, which adds more complex layers of uncertainty to such a strategy.

Despite such clear evidence against IPO over-exuberance from various stock markets, investors periodically succumb to the euphoria of a “hot" primary market and burn their fingers time and again. Behavioural biases that bedevil our subconscious processes of decision-making tend to beguile investors and get the better of them. The second part of this article will delve into these behavioural impulses that drive investors to throng the IPO casino despite knowing that the odds are stacked against them.

Diva Jain is a director at Arrjavv and a ‘probabilist’ who researches and writes on behavioural finance and economics. Her Twitter handle is @DivaJain2

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

MINT SPECIALS

Switch to the Mint app for fast and personalized news - Get App