Mistakes that retail investors make

Retail investors usually get caught up in the frenzy of a bull market and burn their fingers in IPOs, warns Tinesh Bhasin.

Illustration: Uttam Ghosh/Rediff.com

If you need proof that initial public offerings (IPOs) are aggressively priced in a rising market, look at the valuations of insurance companies that are planning to sell their stocks, says G Chokkalingam, founder and managing director of Equinomics Research & Advisory.

These companies are commanding price-to-book (P/B) value of over eight times.

"To take exposure to the finance sector, an investor can instead look at mid- and small-sized banks in the secondary market that are trading at P/B of 1.2 times," he says.

But, retail investors usually get caught up in the frenzy of a bull market and burn their fingers in IPOs. After a few of them perform well, small investors rush to the market to make a quick buck.

Investors don't realise that a correction can destroy their wealth, as seen in the case of many IPOs during the bull run of 2008. Only a few companies that offer stock in a bull market manage to give decent returns over the long term due to their valuations at the time of listing.

Most of the real estate company IPOs between 2006-08 are still trading below their listing price, including DLF, HDIL, Parsvnath and Orbit Corporation.

While DLF is trading at 63 per cent below its issue price, Orbit Corporation is down 97 per cent.

While ICICI Lombard General Insurance and SBI Life Insurance are raising money in September, many other well-known corporates plan to hit the market soon.

Companies such as National Stock Exchange of India, Mahindra Logistics, General Insurance Corporation, New India Assurance, Reliance Nippon Life Asset Management and HDFC Standard Life Insurance are awaiting the regulator's nod to go ahead with their IPOs, according to Prime Database.

If you decide to invest in these IPOs, avoid making mistakes that most retail investors commit.

1. Lured by the grey market

On the face of it, grey market transactions look a win-win for investors. Usually, brokers facilitate the deal.

After deciding on the premium, an individual applies for the IPO.

On receiving the shares, the broker sells stocks in the market or transfers it to the account of a grey market dealer. The applicant gets a fixed profit.

Say, the issue price of a stock is Rs 400 a share. The premium is 20 per cent. An investor can make Rs 80 a share.

There have been cases in the past where the grey market buyers cancelled the transaction when the market fell and the issue is not a success. As a result, the applicant is stuck with unwanted stocks not knowing whether to sell them at a loss or continue holding them.

2. Applying for listing gains

Investment advisors say that most retail investors get into an IPO for listing gains for the lure of a quick profit.

"An investor seeking value would avoid IPOs as the valuations usually don't justify the price," says Jatin Khemani, founder and chief executive officer of Stalwart Advisors, a Securities and Exchange Board of India (Sebi)-registered equity research firm.

Such investments don't follow any other rationale -- investors don't analyse the company to understand its valuations, earnings and prospects. They just apply gauging the interest in the offer.

The logic: If the retail investor, high net worth individual or institutional quota gets oversubscribed in a day, the stock would make huge gains on the first day of its listing.

Avenue Supermarts, the parent firm of D-Mart, for example, listed at over 100 per cent premium to its issue price of Rs 299.

"As investors get lucky with such gains initially, they tend to speculate more and more. But, when the tide turns in the market, the correction catches them on the wrong foot. They even lose the capital employed," says Arun Kejriwal, founder, KRIS, an investment advisory firm.

3. Reason for raising capital

The best way to evaluate an IPO is to look where the company will utilise the proceeds. Most investors ignore this, according to advisors.

In the earlier decades, companies usually came to the market to get money for growth. It's not the same anymore.

These days, companies often approach private equity or venture capital firms to raise capital in their growth phase and come to the market once the business stabilises.

"In many IPOs, you will find that funds are offloading their stake. These funds try to maximise their returns and, therefore, leave little on the table for investors," says Khemani.

While there's nothing wrong with such companies, an investor should give preference to an IPO where the company is raising capital for growth and expansion. Also, avoid those where the proceeds are used for payment of existing loans.

Also, if you don't have the time and capability to read the entire offer document, at least read the part that talks about the risks.

It will help to understand what you are getting into.

Also, don't give a lot of weight to the interest of anchor investors in an IPO. The liquidity conditions dictate the investment rationale of anchor investments.

4. Valuation parameters matter

It's difficult to analyse a company for which there is no listed peer to compare with. As a result, analysts tend to look at how such companies are evaluated internationally. But, it's not necessary that all parameters may be suitable in the Indian context.

When real estate companies came to the market, they were evaluated on their land bank and its future development potential. But, land bank valuations for realty firms are more suitable in mature economies. In India, they did not provide a correct picture.

The best option for an investor is to avoid companies in a new sector if they are not sure of the best parameters to evaluate them.

An investor can always buy the stock after understanding the business two or three quarters later.