8 guidelines to make money from IPOs

Posted on January 2, 2008

8 guidelines to make money from IPOs

There are basically two ways in which you can buy shares: you can either buy them from the stock market, or you can apply for them in a public issue. The stock market is a secondary market where shares are bought and sold, whereas the primary market is one where companies issue shares for the first time.

When a company raises funds by issuing new shares or debentures for sale to the public, it is called a public issue, or an IPO (initial public offering). Such new shares and debentures are called new issues.

New issues of capital can be made both by existing companies as well as by new companies. Bonus shares and rights shares are also new issues but since they are only issued to existing shareholders of the company, they are not called public issues.

Why IPOs are profitable?

Public issues provide you with an opportunity for picking up shares at relatively low prices. Newly formed companies usually offer their shares for subscription at par values, whereas existing companies price their new issues at levels which are sometimes as much as 20 to 30 per cent lower than the market price of their existing shares.

For example, new issues priced at Rs. 12 to Rs. 15 per share may be quoted as high as Rs. 20 to Rs. 25 per share in the secondary market soon after their listing on the bourses.

Similarly, shares issued at par by new companies also quote at high premiums soon after they get listed on the stock exchange. For example, in early 2004 public issues of Maruti Udyog, Indraprastha Gas and Divi’s Labs listed at high premiums.

Equally, most companies, which went in for IPOs in 2005 and 2006 did well. In most cases, the initial days after listing saw the stock prices moving well above the listing prices before settling down in a price range.

Many companies, which listed during this period gave double digit returns, some companies like Indiabulls, Bharati Shipyard, India Infoline. PTC India Limited, Shoppers Stop, Sun TV Limited, Suzlon Energy and Tulip IT Services even gave triple digit returns.

This is the main reason why public issues are so popular with investors; they offer opportunities for making quick money which few other forms of investment can hope to match, match particularly during the market’s bull phase.

The only snag lies in getting a firm allotment of shares. Since most good public issues are heavily oversubscribed, lots have to be drawn and only a few of the applicants succeed in getting a firm allotment. Sometimes the allotment is done on a proportionate basis.

Therefore, you should consider yourself lucky if you get an allotment of even a small number of shares. It is with this background in mind that you should calculate the pros and cons of applying for IPOs.

How to apply for an IPO?

IPOs are generally given widespread, nation-wide publicity through advertisements in newspapers and magazines well before the date fixed for the opening of their issues. These advertisements, along with the other highlights of the issue, give the names and addresses of brokers and the bankers to the issue from whom you can get copies of the prospectus and application forms. If you write to any one of them, they will send you the prospectus and application forms free of cost.

The prospectus is a document inviting the public to purchase or subscribe to the shares of the company. It contains all relevant information you may need to decide whether a company is worth investing in. It would, therefore, be in your interest to read a company’s prospectus carefully before applying for its shares.

The subscription list is required to be kept open for a minimum of three days and a maximum of ten days. Since most of the IPOs are oversubscribed, the subscription list is usually closed immediately after three to five days.

You have to submit your application form and the stipulated application money to any one of the banks or their branches listed on the reverse of the application form. Applications, whether handed personally or sent by post, should reach the bank within the period during which the subscription list remains open.

If you are lucky and get an allotment, the company will send you an allotment letter which will inform you that shares allotted to you have been credited to your demat account.

Nowadays, for IPOs with an issue size of Rs 10 crore (Rs 100 million) or more, shares are issued only in the demat form. For IPOs with an issue size of Rs 100 crore (Rs 1 billion) or more, shares are issued only through the book building process.

Where the IPO is issued through the book building process, reservations are made for QIBs (qualified institutional buyers), non-institutional buyers (large investors), and retail investors who apply for less than Rs 50,000 worth of shares.

What exactly is book building? Book building is a process whereby the demand for a share is ascertained so that it can be issued at the maximum price. Before the opening of the public issue, the lead manager to the issue announces a price band in which the company plans to allot the shares.

For example, in the case ONGC’s [Get Quote] public issue in March 2004 the price band was Rs. 680 to Rs 750 per share. After the issue, the cut-off price is fixed in such a manner that all the shares are offloaded to the QIBs and the public either at, or above, the cut-off price. In this way the company gets the maximum price for its shares.

Companies cannot allot shares arbitrarily. They do so in consultation with the stock exchange authorities. The principles on which allotment is done are heavily weighted in favour of large applicants.

If you are living in a city where one or more bank branches have been designated for accepting application forms, you should give in your application only on the third, or closing, day of the subscription list.

On the first two days you should visit the concerned banks for making an on-the-spot assessment of the public response to the issue. If the public response is poor, then your chances of getting a firm allotment are brighter.

On the other hand, if the public response is very heavy, then your chances of getting an allotment will obviously be very low and it may not be worthwhile to apply at all. The enthusiasm with which the public responds to a particular issue will also give you an idea of the premium the shares are likely to subsequently command after listing.

The greater the public interest in any share, the higher will be the price at which it is later likely to be quoted in the stock markets.

The gap between the issue price of a share and the price at which it is initially quoted on the stock exchange is in the nature of a windfall gain. Should you get a firm allotment in any issue, don’t miss out on the opportunity to encash these gains unless you want to retain the share as a long-term investment for tax purposes.

If you sell a share at a premium soon after it is allotted to you, your money is freed for recycling in other new issues and you can maximise the returns on your investments in public issues.

Guidelines for investing in new issues

New issues can be divided into two broad groups:

New issues of newly formed companies, and

New issues of existing companies.

New issues of existing companies are, by and large, very good investments. They provide an opportunity for acquiring shares in ongoing profit-making companies at relatively low prices. On the other hand, all new issues of newly formed companies are not good investments.

You have to be careful in selecting a new company to invest in, as the incidence of failure among these is quite high. We give below some guidelines, which should help you select the right new issues for investment:

Don’t invest blindly in a company having unknown and untried promoters. First study the performance of other companies set up by the same promoters. If these have done well, then chances of the new one doing well are also high.

Don’t invest in a company, which is not ready to start business operations. This will help you avoid investing in companies, which may have long gestation periods before business operation can commence.

Invest in companies that have something new to offer. Companies introducing a new product or industrial process for the first time, companies proposing to manufacture a product which is currently being imported, companies introducing a technologically advanced or better quality product, or companies venturing into new areas are likely to be better and more remunerative investments.

Invest in companies that operate in high-growth sectors of the economy. The incidence of failure is likely to be lower for such companies.

Avoid investing in very small companies.

Check the reputation and market standing of the foreign collaborator, if there is one. For example, new issues of Vesuvius India [Get Quote] and Birla Ericsson evoked a very good response from investors because of the excellent international reputation of their parent companies.

Companies where the foreign collaborator has an equity stake are often good investments. Foreign collaborators do not readily opt for an equity stake in any company unless they are confident of its bright future prospects.

Do apply for the mega issues of well-known profit-earning companies. The sheer size of such issues ensures better chances of getting a firm allotment. This is what happened in the public issue of the State Bank of India [Get Quote]. The bigger the size of the issue, the better will be your chances of getting a firm allotment.
Excerpt from Profitable Investment in Shares by S S Grewal and Navjot Grewal.

S S Grewal was a practicing investment consultant with an educational backgrand spanning science, engineering, literature, and economics. Navjot Grewal is a specialist in industrial psychology and a keen investor on the stock markets