IPO investing can be lucrative now

Promoters are likely to price them cautiously, thereby leaving value on the table for the primary investor.

The rationale for equity markets is simple. Businesses needs capital and sell stakes in the primary market. Investors want liquidity. Hence, the secondary market where shares can be traded. Secondary market traders want hedges. So the listed stock is used as an underlying for derivatives.

Trading volumes are “inverted” since the economic activity that is most important attracts least interest. The primary market, which enables the key economic activity of helping raise capital, has the lowest volumes. The primary market is lumpy and imperfect, with large deal sizes, low leverage, and discontinuous activity.

The secondary market, which provides continuous price-discovery-cum-valuation mechanisms, is far more liquid. However, here too, day-traders and short-term players generate far more volume than long-term investors. The delivery to trade ratio is low. Day-traders and short-term players employ more leverage Finally, the derivatives markets generate multiples more volumes than secondary spot markets. This is due to the extra leverage of derivatives.

This tail wagging the dog syndrome is seen to some degree across every developed financial market. The primary market cannot exist without the comfort of the price-discovery, hedging and leveraging mechanisms of secondary markets and derivatives. On the other hand, the secondary and derivative markets can chug along through long phases of low IPO activity.

The primary market does possess a more powerful sentiment-signalling system. There is continuous activity in listed shares and derivatives – that means high levels of background “noise” that makes it tough to note changes in sentiment.

The primary market is discontinuous and any activity there is easily noticeable. In India, IPOs quotas are structured such that a new issue cannot be sold or listed without retail participation. That makes it easier to note broad changes in sentiment.

The primary market collapsed in 2008. After the mega-issue by Reliance Power, there has been very little IPO deal-flow. Institutional players were cash-strapped and cautious while individuals were running scared.

Companies that needed to raise capital during the past 18 months have taken recourse to private placements, or debt, or gone overseas. This are very opaque processes and valuations can vary wildly in private placements, especially for unlisted companies.

There is some sign of life in the IPO market again. Adani Power for instance, is launching an IPO. A host of assorted PSUs are trying to organise themselves for the same purpose. NHPC is one of the first in the PSU queue. Those IPOs will go through comfortably only if there has been a genuine change in retail sentiment. Let's assume that the feel-good factor is back or that the government, Sebi, RBI, India Inc, will all work very hard to bring it back. Does this make IPOs worth investing in? That question is very difficult to answer in general terms.

Secondary market performance is tracked easily via standardised indices. In the derivatives markets, every trade is time-bound with exact payoffs. For more than a century, secondary market equity investments have beaten both inflation and returns from less risky instruments.

There are no easy comparatives to judge IPOs. The best one can do is to track a share from IPO offer-price, to listing, to daily traded price, for some designated time period. The methodology can lead to serious arguments.

The offer price is the best the lead-managers hope to get. It may be vastly inflated in terms of intrinsic value or it may be a very conservative estimate. That depends on the sentiment prevailing at the time of IPO. There can also be dramatic changes in price between offer and listing. New companies have higher failure rates and many end up delisted very quickly. The imperfections make the IPO market more dangerous. But they also create circumstances for generating extraordinary returns. Right now, offer pricing is likely to be cautious. There is a chance that IPOs will have to leave value on the table for the primary investor.