In a hyped-up IPO market, what is the best way to play the game in 2025?

Long-term investors should only invest in an IPO when the company's fundamentals are strong and valuations reasonable

 

Altogether companies raised Rs 1.7 trillion through initial public offerings (IPOs) in 2024.  Fund mobilisation through this route is expected to rise and breach the Rs 2 trillion mark in 2025, according to estimates by investment banking firm Pantomath Group. Investors planning to go for IPOs in 2025 should be cognisant of both the risks and the opportunities.

 

Key risks

 

Amid the bullish market conditions of 2024, many IPOs received an overwhelming response. This had consequences for retail investors. “It often led to IPOs coming at inflated valuations,” says Yash Sedani, assistant vice president, investment strategy, 1 Finance.

 

In bullish times, getting the desired allotment becomes a big issue.   

 

In an IPO, investors have limited access to a company’s historical performance, as regulations mandate disclosure of only three years of financial data. Companies often go public during periods of strong performance. In contrast, long-listed companies allow investors the opportunity to evaluate their performance across multiple business cycles.

 

The promoter and the investment bankers determine the pricing in an IPO. They naturally try to get the best possible price for themselves, taking advantage of bullish sentiments. “The pricing of a stock in the secondary market is discovered pricing,” says Sunil Subramaniam, market expert and chief executive officer, Sense and Simplicity, a financial literacy venture. This pricing reflects the consensus opinion of investors (and market sentiment).

 

A lack of knowledge about the antecedents of many of the promoters adds to the risk of investing in IPOs. Experts say this is especially an issue in Small and Medium Enterprise (SME) IPOs.

 

Market sentiment is a key unknown in IPOs. Between the filing of the prospectus and launch of the IPO, sentiment can turn adverse, resulting in a poor response to even a good-quality company. This can have negative consequences for those looking for listing gains.

 

When is it okay to invest?

 

Long-term investors may go for an IPO when a company has a new business model with no listed peers, providing them with an opportunity to diversify their portfolios.

 

They may also go for an IPO when the company has strong fundamentals. “It is advisable to invest in IPOs of entities that have exhibited a good track record and have excellent potential for future growth and sufficient profitability to share with the new investors,” says Jyoti Prakash Gadia, managing director, Resurfent India, a Sebi-registered category one merchant bank.

 

According to Sedani, it is okay to invest in an IPO when the company operates in a promising industry. He also urges investors to check the purpose for which the money is being raised. “The IPO proceeds should be utilised to fund business expansion,” he says.

 

Another good end use is reduction of debt. The money should not go into offering an exit to promoters. “If the promoter is cashing out, it is a sign he does not have much confidence in the business,” says Subramaniam. If venture capital investors are cashing out, that does not necessarily reflect on business prospects as they need to cash out periodically to give returns to their investors.   

 

Gadia adds that it is also okay to invest when the promoters come with a lot of experience, and both the competitive landscape and regulatory environment are favourable for the company. 

 

Mistakes to avoid

 

Avoid falling for the hype surrounding an IPO. “Some unscrupulous promoters paint a very bright picture of growth potential and future earnings. They create high expectations about market share and market capitalisation. Retail investors tend to fall prey to such projections and put in their hard-earned money. False stories of quickly doubling your money need to be avoided,” says Gadia.

 

Investing without adequately researching the company must also be avoided. “Understand the company’s fundamentals and assess its valuations,” says Trivesh D, chief operating officer, Tradejini. He also warns against overexposing one’s portfolio to IPOs.

 

Investors should also be wary of investing in IPOs of companies in cyclical sectors. “The promoter may display the company’s recent good performance and encash his holdings at a high valuation. In the years that follow, performance may go downhill. Investors are then left to bear the brunt of the down cycle,” says Subramaniam.

 

Investing in IPOs when sentiment is bullish and market valuations are high can also prove perilous. Subramaniam suggests waiting. “Markets go through cycles. Even stocks of good companies do become available at a discount at a later stage in the secondary market,” he says.

 

Avoid chasing listing gains blindly. “Listing gains are not guaranteed and funds can get stuck if expectations are not met,” says Trivesh.

 

Investors should be clear about whether they are speculators or investors in the IPO market. Speculators should cut their losses and walk away if they don’t get listing gains so that they have capital for the next bet. It should not be the case that when listing gains don’t materialise, they turn into long-term investors.     

 

 

When to invest in an IPO?

• Invest when the company has a new business model with no listed peers, offering portfolio diversification
• Go for a company that has a solid track record of profitability, and excellent growth potential
• Prioritise IPOs of companies operating in promising industries
• Ensure the IPO proceeds are being used for business expansion, not just to offer an exit to promoters
• Invest when the promoters have significant experience, and the competitive landscape and regulatory environment are favourable

 

When not to invest?

• Avoid IPOs promoted with exaggerated growth and earnings projections
• Avoid investing at high valuations in highly bullish markets
• Be cautious of IPOs in cyclical sectors where promoters may capitalise on current good performance

(The writer is a Mumbai-based independent financial journalist)