IPO – What is the Dark Side of Investing in an IPO

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This Guest Post has been written by Money Theory and published by FinMedium.

Recently, you should have witnessed many companies going public with an IPO and some rained money at the time of listing. Today, I will take you to the dark side of an IPO.

Grab a bowl of popcorn and let’s get started.

First things first, let’s understand the basics of an IPO in four points.

1. There is a business that needs funds. Whatever the reason might be.

2. It decides to sell its shares to the public.

3. It appoints an investment banker to assist in the process of so-called listing.

4. It receives money from the public, undertakes allotment, and get its business listed on the stock exchange.

Short story short, An IPO stands for Initial (First time) Public (You & me) Offering (Offer for shares) That’s it. Let’s move on to the main theme.

Dark Side of Investing in an IPO

Dark Side of Investing in an IPO

Source: ET

1. Promoter mindset: The promoter is the founder of the company. Generally, he is the person who sells shares to the public.

Now think for a moment, the promoter receives money only once at the time of listing as later on the shares trade in the secondary market. So, the logical move would be ‘Sell minimum shares at a maximum price’ To do this, he needs market peaks, not market bottoms.

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And that’s the reason u see many IPOs coming in a bull market.

Having said that, we got some genuine IPOs in the past. However, the trait is rare.

2. Recency bias: People generally give high importance to recent events compared to historical events.

This is called recency bias. For instance, an individual expects rising markets to rise further and falling markets to fall further.

And with big advertisement campaigns and fancy words like grey market premium your greed login into your brokerage account and apply for IPO despite their long-term underperformance.

3. Survivorship bias: This is one of the common mistakes you can make. Say, 100 companies went public since 2010.

98 companies out of these 100 have either closed their business or gave terrible to average returns.

And only 2 companies have given extraordinary returns. And now the person sees the returns of these 2 companies and claim IPOs to be wealth creators. Wola! Come on man, you have ignored the 98 losers.

The win rate is only 2%. This is called survivorship bias.

4. Lottery Allotment: If you are new to betting/gambling, welcome to the IPO market and bet on some IPO here and there as retail allotment & listing gains works in the same way.

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Mr. Rock (1986) said that there are two types of investors. The first group makes informed decisions and the second group makes uninformed decisions.

When a company issues shares to the public, informed investor read all documents and applies only if it is favorable to him.

Whereas an uninformed investor applies for an IPO without understanding the business. So, a good issue will be oversubscribed as both investors apply thereby decreasing allotment chance to uninformed investors.

Whereas on a bad issue, the informed investor takes a step back and the uninformed investor applies and gets a full allotment of shares.

5. Inadequate data: The company that is going public gives you very limited information (say 3 years of financials) to make a decision.

Whereas an existing company provides you a lot of data for prudent decision making.

6. Under-pricing myth: No idea why, but some people think that the company underprices the issue which is far from logic.

Even when u see whopping listing gains, it has more to do with the failure of investment bankers to capture the market mood rather than under-pricing.

7. Cooking books: This is a less obvious one compared to the other points. However, a company may manipulate its books of accounts exhibiting high growth rates to get a higher valuation for the business.

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8. Lock-up period: It is a provision preventing insiders who already have shares with them, from selling on the listing date.

Generally, it varies from 90 days to 180 days. It is a good provision with one small problem attached to it.

The problem is after the completion of this lock-up period, the stock may see selling pressure from insiders who are planning to exit thereby decreasing the stock price.

All in all, an IPO is not a good investment vehicle for the long-term investor provided its flaws.

That’s it, folks. Hope you enjoyed reading. Have a great day.

This Guest Post has been written by Money Theory and published by FinMedium.

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Cover Image: ET

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