From the buoyant highs of Nykaa to the dismal depths of Paytm, Indian Initial Public Offerings (IPOs) have been on a roller-coaster ride through the crowded IPO amusement park on Dalal Street for the past few months. With merchant bankers and brokers acting as advocates of India’s “best” companies, investors on fair grounds have flocked to the game of IPO flipping to roll the dice. What most investors seem to be missing in their liquidity- IPO casinos is a sober understanding of the economics of Sojourn IPOs and their post-listing performance. The almost mythical devotion and frenzied admiration of investors for IPOs that welcome the entry of some firms into our public markets for their “unique” and “disruptive” business models beg the following questions: How have IPOs performed historically? ?
Academic studies offer tremendous evidence that IPOs tend to cluster over time and by industry. These “hot” and “cold” cycles prompt the question of whether firms really need capital at the same time. Studies have shown that the “clustering of investments” hypothesis as an explanation for IPO market cycles is weak. Most IPO firms do not require immediate funding, and companies that enter the market to raise funds during “hot” and “cold” periods. There doesn’t seem to be a difference 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 efforts by managers. This is further complicated by an information asymmetry that underlies the use of IPOs, with better-informed insiders and early backers often wanting to lower their bets on less-informed public market investors.
The evidence for the long-term 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-return was a shockingly negative 15.8%. Companies that have gone public in years with high IPO volumes (or in “hot” markets) tend to underperform other IPOs. A Nasdaq study shows that 64% of IPO firms outperform the market by more than 10% in the three years after listing. Qualitatively similar results apply to the Indian markets.
IPO enthusiasts may now assume that the prolonged poor performance of IPOs is due to an unpredictable market uncertainty and not due to deficiencies in the business models of these companies. It is possible, but not likely. Jain and Kinney found that the operating performance of IPO firms declined significantly after the listing, indicating that the poor performance of the market is driven by the weakness of the business and not by the emotionally volatile Mr Markets. Some debutants also use accounting tricks such as sharply reducing their marketing spend just before an IPO to show higher profitability and a cosmetic makeover to a business model that is exposed after listing enthusiasm wanes. could.
There is a rich storehouse of IPO anecdotes in the Indian markets. India has seen three major IPO cycles – in 2007, 2010 and now in 2021. During the 2007 cycle, education stocks such as Educomp and Avron attracted the likes of IPO investors, who featured them with listing gains of 123% and 241%, respectively. Educomp is currently trading at less than a tenth of its listing price, while Everon has been delisted. Similarly, in the 2010 cycle, the biggest listing profit was posted by CareerPoint Infosystems (103%), which now trades at half of its issue price. On the other hand, IPOs that come on the day of listing can be surprisingly profitable in the long run. The biggest wealth makers of the 2007 IPO cycle have been Astral Poly and Page Industries, which are up 20x and 10x respectively since listing. Both these IPOs were down on the day of listing: Astral Poly 10% and Page 21%.
Internationally, Google had to drastically cut its offer price prior to the IPO, and despite listing its ‘pop’, its offering was widely seen as a failure. Facebook had no listing pop, and its stock fell to less than half its offer price in the days following its listing. These anecdotes reinforce the idea that IPO listing returns are volatile and tell little about the quality of the business.
While there is no doubt about the eventual underperformance of most IPOs, trigger-happy traders can argue that IPO listings are ideal for reaping the profits that seem to be plentiful in this market. However, my analysis shows that the quest to list profit is fraught with risk. In 2021, the average IPO listing day return was 26.4%. This number sounds impressive as long as it is combined with the standard deviation (which indicates risk) of these returns – a whopping 41.5%. For an IPO trader trying to capture listing gains, this number translates to a Sharpe ratio of 0.49, which is much lower than the average exchange-traded fund tracking the NSE Nifty. Listing gains not only come with disproportionate risk, a harvesting strategy requires huge leverage to muscle through oversubscribed allocation, which adds more complex layers of uncertainty to such a strategy.
Despite such clear evidence against IPO over-enthusiasm from various stock exchanges, investors do succumb to the excitement of a “hot” primary market from time to time and burn their fingers time and again. Behavioral biases that affect our subconscious processes of decision making confuse investors and get the better of them. The second part of this article will delve into these behavioral impulses that drive investors to IPO casinos despite knowing that the odds are stacked against them.
Diva Jain is a director and a ‘probabilist’ at Arjav, who researches and writes on behavioral finance and economics. His Twitter handle @DivaJain2 . Is
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