IPO Investment Tips: Strategies for Investing in IPO

IPOs are usually very popular among retail investors. The recent IPOs like Burger King and Mrs Bector's have given 150% and 57% returns since their listing days (as on 11/01/2021).

Such massive returns on these IPOs have made retail investors feel strongly that investing in IPOs will give guaranteed huge returns.

While investing in fundamentally strong companies will give good returns, not all IPOs are successful. For instance, Sterling & Wilson Solar, which launched its IPO in 2019, now trades at one-third of the IPO price.

Investment in an IPO can often make or break a deal for retail investors. Hence, tips from social media, friends, relatives will not often work for you in reality. However, there are some basic strategies that investors should consider when planning to invest in IPOs.

So, let's see the most recommended IPO investment tips that have proven to work for most of the investors.

Introduction to Initial Public Offering

For the amateur - an IPO or the Initial Public Offering is a proposal of new shares of a private company to the general public for the first time. The proposed shares are bid upon by the investors, which are then allocated to successful bidders. When the IPO process comes to an end, the allocated shares from an IPO can then be traded on the listed stock exchange.

IPO Investment tips:

Read the Red Herring Prospectus

A significant IPO investing tip is to thoroughly analyze the red herring prospectus. You become an equity shareholder of the company when you invest in an IPO. 

For that reason, you are required to read the red herring prospectus in detail to comprehend the importance of your investment. 

The red herring prospectus will help you recognize: 

• Background of the company
• Information of the promoters
• Motives behind the IPO 
• Threats to the company
• What the company plans to do with the money etc. 

A red herring prospectus of a company is a vital document which should be analyzed carefully, prior to an IPO investment.

In-depth Research

When you invest in IPOs, most often you will be investing in private companies. Since private companies do not have strict disclosure norms, most often, these companies hide crucial data from the general public.

Even though self-styled 'experts' review IPOs, they are only looking at the openly available information. These experts do not perform in-depth research about the financials or internal workings of the company. 

It's true that the red herring prospectus gives us a good description of the company and is also accepted by SEBI. But always keep in mind, the company itself creates the red herring prospectus, and the company will most probably attempt to conceal all negative facts to preserve its status. 

Hence, before investing in an IPO, perform your own research and do not depend on a third party entirely. You should perfectly evaluate the company's functioning in contradiction of its peers, whole sector analysis and its forthcoming growth forecasts.

Explore the Promoters & Management

Time and again, it has been seen that IPOs act like an exit-window for the promoters. Thus, before investing in an IPO, perform a background inspection on the promoters and their involvement with the company. Moreover, examine the capability of the company's management. 

Prudent investors such as Vijay Kedia, Charlie Munger pay superior consideration to a company's management. 

The superiority of management differentiates a high growth company from a poor growth company. A sound management team can administer a company through short-term crises and generate a fortune for investors. 

Therefore, a vital IPO investment tip is to put your money in companies with sound management. 

Know where your Funds are Invested

A red herring prospectus just tells you the company's plan to utilize raised funds. Knowing this is crucial for an IPO investment. If the sole motto of IPO is to repay its liabilities, then it is not a very optimistic sign.

On the other hand, if a company is raising funds for business expansion and research & development, then that IPO investment can be very fruitful.  

Invest in IPOs Backed by Strong Brokers

IPOs are generally handled by brokers. Though there is no instruction that large brokers won't underwrite weak companies, typically it doesn't happen. Large brokers have their own status to maintain, and so, they will underwrite IPOs for only fundamentally strong companies. 

However, just the fact that a large broker is underwriting the IPO should not be the sole reason for your investment. 

For instance, Kotak Mahindra Capital & Morgan Stanley had underwritten the Hathway Cable & Datacom IPO, and the IPO's listing returns were -82.68%!

Nonetheless, comparably, small brokers can simply be bought, and they may underwrite poor IPOs as well. Therefore, when you are investing in IPOs, try to invest in the one which is backed by a large reputed broker.  

Valuations Matter

It is problematic for retail investors to realize the accurate valuations of a private company. Although underwriters and investment bankers make an effort to calculate the valuations on the ground of management and returns, you ought to also set up valuation levels to evaluate the company against its contemporaries.

Be Sceptical

IPO investments are believed to be safe. But this is not always true. Given that limited data is accessible publicly, investors mostly count on the broker's advice for investing in IPOs. Habitually, brokers aim high net worth individuals and institutions for IPOs investments.  

Consequently, if your broker endorses an IPO to you, then be sceptical as it happens due to the reason that HNIs and institutional investors are not interested in investing in that specific IPO and the broker is endorsing you that IPO only to make a sale.

Invest at Cut-off Price

IPO Investment is said to be a game of luck. While investing in IPOs, you have to bid on a price that falls inside the price band stated by the company. You should bid at the cut-off price to make sure that you get the IPO allotment. By doing so, at best, your application will be considered regardless of the closing allotment price.  

Understand the Lock-in Period

This IPO investment tip is truly significant for retail investors. There is a legal agreement between underwriters and insiders for holding shares.

If the underwriter initiates selling of shares once the lock-in period is over, then definitely the share prices will drop. This implies that the brokers are not assured of the company's forthcoming prospects.

Likewise, if the underwriters hold the shares even though the lock-in period is over, then it is a good signal as it displays confidence in the company's forthcoming prospects.

Closing words

IPOs are a good way for companies to raise funds. But then again, every company does not raise funds for all good reasons. Few might raise funds just to pay off their liabilities, which can mean that your hard-earned money will be spent only to pay off someone's debt, and not for progress. 

Lastly, it's always prudent to make multiple bids in a situation when you're convinced about the predictions of an IPO, and shares perhaps get oversubscribed. This enlarges the probabilities of getting a greater number of shares.