Use grades for guidance, not decisions

According to a recent study by the Credit Rating and Information Services of India (Crisil), stocks that received a higher grade for their initial public offerings (IPOs) are trading at a higher price-to-equity multiple. The agency evaluated the performance of 117 stocks that were listed between May 2007 and December 2010. These results are in line with the credit rating agency’s previous studies carried out in May 2009 and January and July in 2010.

The Securities and Exchange Board of India (Sebi) made grading of IPOs compulsory from May 2007, to assist investors in evaluating the offers. Rating agencies such as Crisil, CARE, Fitch and others registered with Sebi grade IPOs on a scale of 1 to 5, where 1 indicates poor fundamentals and 5 strong.

However, the process has often been regarded as futile by brokers and investment bankers, as it focuses purely on the fundamentals of the company. They believe it does not enable investors to make any investment decision. The grade does not even factor in the issue price.

Thus, investors cannot look to the IPO grade for guidance on the pricing of the issue — whether at a premium or discount. For this, they must compare the issue price separately with listed peers or consult analyst reports and take an independent judgment regarding the price at which to bid or subscribe.

Moreover, the grade provides no indication of the performance of the scrip. Take the example of SKS Microfinance. Its IPO was graded 4/5 (indicating above average fundamentals) by the rating agency, CARE. As of today, the scrip is trading at 51 per cent below its issue price. Thus, traders or those merely looking listing gains will find IPO grades of little or no use.

The grades are issued by rating agencies after studying the company’s business prospects, competitive position, financial position, management quality, corporate governance practices, compliance and litigation history, new projects (risks and prospects), etc.

The cost of the grading process has to be borne by the issuer. And, it must be acceptable, irrespective of the findings. The company may, however, choose to get the grading from more than one agency. But in this case, they must disclose all the grades received and carry the comments from each agency in the prospectus.

Investors are, however, cautioned to not look at the IPO grade as a recommendation. They should view the grade together with the disclosures made in the prospectus, including the risk factors.

Rather, simply use it as one of the parameters for investing. Long-term investors could use the IPO grades for investing in fundamentally strong companies.