And worst of all, patient

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Step 1: Don't

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It's raining IPOs here in India. A string of IPOs and the associated media blitz can hardly fail to affect the retail investor. Companies, once listed, immediately jump up in price showing an almost instantaneous profit. To most, it would seem that IPOs are one of the easiest (legal) ways to a quick buck on the market today. And they're right, but only if they're the ones doing the selling.


IPOs and bull markets

According to Benjamin Graham, the sign of the tail end of a bull market is this: IPOs of sub-standard companies at premium valuations. Bull markets are characterized by excessive optimism and high liquidity. In other words, people have a lot of money and are willing to pay a lot for companies since they see a bright future ahead. Can you think of a better environment to sell? The charter of any company is to maximise the amount of money received for its shares. If the company sees the time as ripe for selling, why would you think it's the right time to buy?

Pay the Price

This is an excerpt from the Basis for Issue Price from the Royal Orchid Hotels red herring prospectus where the company explains why you ought to pay what they are asking for. The choice of this company was slightly less than random. They're based here in Bangalore and, I confess, I like their buffet.

Price/Earnings (P/E)* ratio in relation to Issue Price of Rs. [•]
a. Based on year ended March 31, 2005 consolidated EPS of Rs. 6.36 - [•]
b. Based on weighted average consolidated EPS of Rs. 3.91 - [•]
c. Industry P/E**
i. Highest - 96.0
ii. Lowest – 3.8
iii. Industry Composite – 34.2
*would be calculated after discovery of the Issue Price through Book-building
** Capital Market Issue dated December 19, 2005 –January 1, 2006, Category - Hotels

The argument they make is that a P/E of 34.2 is fair for the industry and ought to be the minimum you should pay along with a premium for the growth potential of this company. The investor's line of thinking should instead be: The industry is already historically overvalued and, based on this company's short history of exponential growth and continuation of the same, I should pay more than I would for well-established firms even in the same industry.

There! makes it easier to say no, doesn't it?

Exponential growth, or else...

As with any other growth stock, investors expect the IPO company to just keep growing at the same pace. A slowdown in growth rate is enough to make the investors jittery and the stock price falls like a buttered brick. God help them if there is actually a fall in profits. If you think that's unlikely, consider these statistics based on a study of 452 IPOs:

1. 69% were afflicted by declining sales and earnings trends while only 14% showed improvement

2. Almost 80% achieved peak profit margins within four quarters before or after their offerings. SIXTY percent then slipped in profitability within two years of their IPO.

3. A quarterly earnings drop in the first four quarters after the IPO occurred in 58% of the companies. More than 75% had a decline within two years.

4. 1/3 of the companies had a sales decline within four quarters and 45% had a sales drop within two years.

5. 19% actually lost money in one of the first four quarters after the IPO.

6. 25% lost money throughout the two year period of the study.

Everyone wins (except you)

The company goes IPO on strength of growth for the past few years and when its sector is 'hot'. Thus, it is almost guaranteed to be over-valued. The underwriter of the IPO gets a ~7% commission of which 33% is profit. Any brokerage firm gets in on this action via transaction fees from participating retail investors. Given this, do you really expect any of these people to tell you not to buy into the IPO?