Are you worried about the recent volatility in the Stock Market? Are you confused what to buy, sell or hold? The newsletter selects quality mid-caps and small-caps for investors with a long-term perspective and provides timely buy/sell/hold suggestions. Send an email (to address in profile below) for subscription details today.

Thursday, February 11, 2010

Why small investors should avoid IPOs, FPOs (and NFOs)

Before I delve into the details, I think it may be prudent to clarify what the TLAs (Three Letter Acronyms) mean.

IPO stands for 'initial public offering'. That means a company is issuing shares to the general public for the first time. (It may have issued shares to promoters and private investors, but such shares were not traded in a stock exchange.) IPOs are issued at 'face value' plus a premium.

FPO means a 'follow-on public offer'. Companies may have sold a small percentage of shares, say 10% or 20% of their authorised equity capital, earlier. Now they need more money for expansion and/or to retire debt. An FPO is different from a rights issue - where shares are offered only to existing shareholders. FPOs are also issued at face value plus a premium.

NFO is a 'new fund offering' from a mutual fund house. Fund houses earlier called these IPOs, but were compelled by the authorities to change the name. Why?

Because a new fund has no prior track record whatsoever, unlike most companies that have to be in business for a while and attain a particular balance sheet size before they can issue shares. NFOs are issued at face value.

The short answer to the question (and I'm not sure that the authorities will be terribly pleased with it): Because investors get taken for a ride.

Aren't IPOs and FPOs tickets to quick riches? It used to be so in the 1970s and 1980s when the pricing was pre-approved by the stock exchanges, and there was enough left on the table for investors.

The current practice of pricing shares through a book-building process(and a French auction for the recent NTPC FPO) is supposed to 'discover' the best price, but actually causes uncertainty and confusion among small investors.

The 'red-herring prospectus' that is supposed to be part of the offer document including the application form, is either not available, or printed in tiny nano fonts that require a powerful microscope to read, or too voluminous to comprehend.

The end result? Most investors fill up the application forms without going through the company details - particularly the risk factors, including pending litigation, unpaid tax demands, potential forex losses and myriad other issues that are conveniently hidden in the fine print.

Even if investors have the patience to go through all the details, it is unlikely that they will be enlightened because of forward-looking statements (read 'pure fiction') about the future growth and profitability prospects of the company.

On top of it, the price-band given for the book-building process is mostly way higher than reasonable, aimed at squeezing out the last Rupee from the pockets of gullible investors.

Compound that with the fact that most IPOs, FPOs (and NFOs) appear when the stock market is at or near a peak - and you have got a perfect recipe for making losses.

Get-rich-quick schemes - in the stock market or otherwise - never benefit the investors. It is meant for the benefit of those who sell such schemes. So stay away from IPOs, FPOs (and NFOs). Stick to the tried, tested and trusted companies and funds. You will get rich - slowly.

(A hypothetical question for investors. Some one holds a gun to your head and forces you to invest in any one of three IPOs. The first company is raising money to retire its bloated debt. The second company is raising money for some planned acquisitions. The third company is planning to buy new plant and machinery for an expansion project. Which of the three IPOs will you subscribe to, and why?)


SG Money Mind said...

I shall go for the third one.


I would like to invest in The third company which is planning to buy new plant and machinery for an expansion project.

The choice no 1 is not preferable as company has expanded or doing operation without thinking about the debt and interest payment. After getting the debt paid there will not be any guarantee that it will not come again with debt obligation. We have seen things in Real estate companies in past.

Choice no 2 is not preferred as they are going for acquisition and there will be risk of integration and price it is paying for the acquisition.

The third one will suited most as company needs capital for expansion which they already have experience. The expansion will lower down the current running cost due to large capacity.
Which will ensure high return on capital.

Rishi said...

With a gun pointed at my head, i would opt for the 3rd option - the company looking for expansion.

The reason
1. The IPO amount would be utilized for buying more machinery which would bare minimum increase book value in near future.
2. I doubt the plant and machinery would remain unused. It would be used to manufacture products which will increase inventory. A prudent company would take measures to sell inventories and make money.

Either of the above would happen if not for a scandalous promoter.

Why I would avoid the other 2?
Option 1.
What would be the reason for a bloated debt?
1. It can be a high capital intensive business, which i would like to avoid.
2. It can have Debt via large stake by PE investors and they wanted to exit. PE investors would take all/part of the IPO money, leaving very small for the company to grow.
Example, Recent NTPC FPO - Government would take all money to negate the fisical deficit and what would remain for the company to grow in future? Domino' IPO, where a few investors are exiting from the business.

In general Leverage is good, but a bloated one doesn't put faith on company' management. Thriving on other' money for a long time is like having a dangling knife on your neck.

Option 2:
This choice depends on the sector the company is in.
Companies in service sector grows inorganically by acquisitions.
1. Acquisitions can turn good, but it can fail too. If synergy doesn't happen, then the company is in soup.

If there is no gun, i would not opt for any.

I went through a few Read Herring Prospectus filed recently and found the picture doesn't look rosy as I perceived to be from outside. Examples would be Dominos and Talwalkars. My thought was a gym/pizza store setup once would earn good amount of money in the future, but from what they say I am not very confident and price doesnt leave anything for the investor. I am not enlightened.

Bharath said...

Hi dada,
I won't look into the purpose for the company to raise money , instead will check 1) the Management and its historical records. 2) Next will give importance to Care/IPO ratings wrt financial strength and will look in financial books.3) Finally will look into the valuations of the share/pricing comparing it to its peers. Considering all the above factors , will select one among them :)

Eswar Santhosh said...

I have not come across even a decently priced IPO/FPO in the past year or so. So, I'd try to trick my way out of the situation ;)

On the surface, it should be the third option.

But, the factors that influence one's decision should be valuation, track record (execution record, to be precise), sector, moat and most importantly - attitude towards shareholders. In the case of an unknown company where rosy details are given by the management, I'd not take the risk of going for anything other than [3].

But, if the management is genuinely trying to wriggle out of debt, option [1] can be considered. What if the company's sector is coming out of a bad patch?

In case of option [2], there's a chance of Di-worsifying, no doubt. But, what if the Company is making an acquisition in it's field of expertise - a distressed asset in the US for the right price, for example. What if the acquisition gives it a global footprint?

So, nothing should be rejected on the face of it unless other details are available and considered.

Subhankar said...

Appreciate your responses. Guess I gave away too many hints! Next time I'll ask a tougher question.

@SGMM: You get only three brownie points for not explaining the (correct) choice!

@CHINTAN: You get seven brownie points. I'm suspicious of any company raising money to retire debt. Points to the debt burden being unmanageable.

@Rishi: You get eight brownie points - one more than Chintan for adding the last paragraph. Acquisitions are generally value-destructive for share holders. Notice how Infosys has been very careful in acquiring other companies, even though they have a load of cash. Contrast that with 3i Infotech and Subex. Both got into trouble by funding acquisitions through debt.

@Bharath: You get no brownie points at all for copping out! :-(
When some one points a gun at your head (God forbid!), you are unlikely to get a chance to look at ratings and valuations.

@Eswar: You get six brownie points. The last paragraph cost you one!

SG Money Mind said...

For me the most important point is the gun had to be removed from my head. The way others went through, they may have invested their money even in a difficult situation, but would have lost their life. So every second counts in an adverse situation. Even though I got the least no. of brownie points, I am still alive, which means, I can still sell the stock in this IPO mad crowd and wash off my hands from the investment as well as the grave danger. :)