'IPOs should be seen as an opportunity to buy good companies at a very early stage'

Amid the ongoing bull run, the IPO market is booming as well. Many stocks have given handsome returns on the listing day, so it's obvious for investors to be attracted towards IPOs. We speak with Bharat Lahoti of Edelweiss Mutual Fund about how one should approach IPOs. We also understand from him the various analytical challenges with new companies, especially start-ups. Lahoti manages Edelweiss Recently Listed IPO Fund.

The IPO market is booming, both in terms of returns given by newly listed stocks and the number of issuances. What's responsible for this?
It is normal to have large primary issuances in a bull market. We had seen a similar trend in 2017, where we saw 36 IPOs with an average listing-day gain of 20 per cent. This year too, so far, we have seen 38 IPOs, with an average listing gain of 26 per cent. Apart from the easy availability of liquidity and buoyancy in the market, there are also structural reasons for many companies tapping the IPO market. Over the last few years, many investments were done by PE/VC firms in India in emerging business ideas which were expected to be benefit from reforms, financialisation of savings, formalisation of economy, rising per-capital income and changing customer preferences for goods and services. When these PE/VC funds mature, they tend to exit their successful investee companies and an IPO is one of the most preferred routes. Along with this, as private capex is picking up, promoters are also gearing up to raise capital through the IPO route, creating a booming market.

You manage Edelweiss Recently Listed IPO Fund. How do you pick stocks for it? What kind of stocks do you avoid?
Edelweiss Recently Listed IPO Fund is a thematic fund. The idea of this fund is to pick good new-age business which come through the IPO route. We are extremely selective in choosing an IPO for our portfolio. Over the last five years, there were about 175 IPOs and this fund in its life of over 3.5 years has selected about 70 companies in its portfolio, out which we continue to hold about 42 companies in our current portfolio. This year too, out of 38 issuances, we have participated only in 13 of them in our core portfolio. We avoid stocks based on stringent criteria like debt/equity, interest coverage, cash conversion, ROE/ROCE, questionable corporate-governance practices, poor promoter track record.

IPOs typically tend to have high valuations, which also tend to get stretched as the company lists at a premium. How do you deal with overvaluation in recently listed companies?
In general, IPO stocks display a positive earnings trajectory in their financial statements during filings. The nature of earnings momentum, i.e., cyclical or secular is often mis-judged and consequently valuations become tricky. Many emerging companies, due to a differential approach in delivering goods and services, continue to deliver sector/market-leading growth, leading to valuation upgrades over a period of time. Our approach is to classify companies in two buckets: secular ideas and cyclical ideas. For secular ideas, we look at valuations in the broader context of markets, opportunity size, competitive advantage and growth expectation. For cyclical ideas, we remain cautious and look for niche opportunities in these sectors at reasonable valuations.

This year has seen a couple of start-ups, such as Zomato, listing on the Street. Quite a few are in the pipeline. With profits often missing from their books, how can one evaluate such companies? How risky is it to invest in a loss-making start-up?
Investing in loss-making start-ups is always a challenge, so one needs to be extremely cautious while evaluating them. In such companies, it's more important to look at unit economics, assessing the addressable market size, pathway to profitability and levers which can alter these parameters. One also needs to look at optional adjacent business that a start-up can look upon, given the current capability and data analytics it produces. There are many moving parts in assessing the future of start-ups. Consequently, a reasonable margin of safety in assumptions should be used while doing financial modelling. Start-ups are also extremely agile, which helps them to adapt to the new environment quickly but also often possess the risk of capital misallocation, so these companies also need to be tracked more actively vs established businesses.

Another problem with evaluating new-generation companies is that they often don't have listed peers. How can one get around this problem? Please give relevant examples.
Relative valuation sometimes becomes challenging as many IPOs don't have a direct domestic comparable and a few are also the first to list in their sectors. We look at broader business themes and adjust for difference in business models while valuing companies. We also try to look at global comparable companies and adjust valuations for differential in growth and cost of equity. Say, for a domestic credit-card company, we benchmark with global credit-card companies, such as AmEx, Visa, etc.

What should an investor see in an IPO before applying for it? If he doesn't get an allotment due to oversubscription, what would you advise such an investor to do?
While IPO investing looks pretty simple, for a retail investor, it is very difficult to build wealth from IPO investing. The data, access to companies and historical trends are limited during IPO times, so research becomes challenging. Moreover, all IPOs don't make money, with more than one-third IPOs still below their issue price, so selection remains a challenge in IPOs. Also, IPO listing-day returns have a high correlation with retail subscription numbers. Hence, oversubscription limits the access for a retail investor in IPOs, especially those that perform exceedingly well. To overcome this problem, investing via a fund is better for retail investors. Institutional investors have the advantage of a better access to management for evaluating the right set of IPOs and the ability to participate in anchor deals, leading to a better access to the IPO market.

Investing in IPOs is often equated with investing for listing gains. This brings in an element of speculation and short-termism. What do you personally think about the existing IPO mechanism? What can be improved in it?
In our view, IPOs should be seen as an opportunity to buy good companies at a very early stage and not just from the perspective of listing-day gains. Real wealth gets created for good companies where earnings momentum continues, if held for a long period of time. Most retail investors do cash out on the first day of listing, treating IPOs as short-term strategy. Retail investors also miss the value migration seen in many IPO companies, where small caps/mid caps become mid caps/large caps, as they don't think about the potential of many companies in the long run. Our research for the last five years of IPOs shows that companies generating above-median returns on the listing day have generated additional 30 per cent returns approximately in the next one year post listing. Thus, if selected well, additional returns can be made on the incremental capital and not just on the IPO-allotment amount.

What's your outlook for the market in general? With the indices hitting new highs virtually daily, what would be your advice to the investor who doesn't want to bear the pain of a deep correction and at the same time revel in the party?
In our opinion, waiting for big correction and staying outside the equity market is not the best strategy for any investor. In our view, a retail investor should continue investing in equity if asset allocation permits and preferably via SIPs. Investors should also look at their equity portfolios closely and add a new scheme only if it offers true diversification to the existing portfolio. Investors who do not want to bear the pain of a deep correction and yet want to take advantage of a rising market can look at dynamic asset allocation/balanced advantage funds as these funds will automatically alter the allocation based on market conditions.

Note: This interview was conducted on September 20, 2021, and quotes data as of then.