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11 Common IPO Mistakes and How to Avoid them

12 months ago
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Here we explain 11 common and biggest mistakes IPO investors have done in the past with real life examples, which you should not. Use this guide where we also explain how you can avoid them in your IPO investment journey.

#1. Investing For Listing Gains

The pursuit of quick profits often entices investors to engage in the practice of investing for listing gains in IPOs. While the greed of immediate returns is understandable, a focus only on short-term gains can lead to hasty decisions and may not align with a comprehensive investment strategy.

Listing gains refer to the profits made by investors when the stock begins trading on the exchange after the IPO. Investors aiming for listing gains typically anticipate that the demand for the IPO will drive up the stock price immediately upon listing.

Pitfalls of Investing for Listing Gains:

  1. Short-Term Focus: A strategy solely focused on listing gains may neglect the long-term potential of the company. Stocks that perform well on the listing day may not sustain the momentum in the following months.
  2. Market Volatility: The stock market can be unpredictable, and listing gains are influenced by various short-term factors. Volatility can lead to unexpected fluctuations, affecting the profitability of short-term investments.
  3. Missed Long-Term Opportunities: Companies with strong fundamentals may not experience significant listing gains but could present attractive long-term investment opportunities. Ignoring such companies may result in missed potential for wealth creation.

Real-Life Example: D-Mart IPO (2017):

The D-Mart IPO in 2017 witnessed substantial listing gains, with the stock soaring on its debut. Investors who focused primarily on listing gains experienced initial success.

However, the long-term performance of the stock demonstrated that sustainable growth goes beyond the excitement of the listing day.

Also Read : What are Pre-IPO stocks (Unlisted shares) – Benefits and Risks

#2. Paying too much attention to the grey market

The grey market, also known as the unofficial or parallel market, is a space where shares of an IPO are bought and sold before the official listing on the stock exchange. Grey market premiums, indicative of the difference between the IPO price and the expected listing price, can be a tempting metric for investors.

A high premium might seem like a signal of robust demand and future profitability. However, the history of IPOs in the Indian stock market offers cautionary tales about relying solely on grey market cues.

Why Grey Market Dynamics Can be Misleading:

  1. Limited Regulatory Oversight: The grey market operates beyond the purview of regulatory bodies, making it susceptible to manipulation and speculative activities.
  2. Incomplete Information: Grey market participants may not have access to all relevant information about the IPO, leading to incomplete assessments.
  3. Changing Market Conditions: Market sentiment can shift rapidly, and the grey market may not accurately reflect real-time changes in investor perception.

Real-Life Example: IRCTC IPO (2019):

The IRCTC IPO in 2019 serves as an illustrative case. The grey market for IRCTC was buzzing with enthusiasm, with premium rates reaching significant levels. Investors, influenced by the seemingly strong demand in the grey market, flocked to participate in the IPO with high expectations.

However, when the IPO eventually listed on the stock exchange, the market response was more tempered than anticipated. The gap between the grey market expectations and the actual listing performance showcased the inherent risks of relying exclusively on unofficial channels for decision-making.

#3. Following the herd

The herd mentality in investing refers to the tendency of individuals to mirror the actions of the majority, often driven by fear of missing out (FOMO) or the assumption that a large group can’t be wrong. In the context of IPOs, this behavior becomes particularly pronounced, as the fear of missing out on a potentially lucrative opportunity can lead investors to make decisions based on collective sentiment rather than individual analysis.

Why Following the Herd Can be Detrimental:

  1. Lack of Individual Analysis: Investors may forego independent research and analysis, relying solely on the collective actions of others.
  2. Delayed Reaction to Changing Circumstances: The herd often reacts after significant market movements have already occurred, resulting in delayed responses to changing circumstances.
  3. Exaggeration of Market Sentiment: Collective actions can sometimes exaggerate market sentiment, leading to inflated valuations and increased volatility.

Real-Life Example: Vodafone Idea IPO (2007):

The Vodafone Idea IPO in 2007 provides a poignant example of the perils of herd mentality. The telecommunications sector was booming, and the IPO generated immense interest, resulting in massive oversubscription. Retail and institutional investors alike rushed to secure their share of the offering, driven by the belief that the widespread enthusiasm was a testament to the IPO’s guaranteed success.

However, the subsequent years saw significant challenges for Vodafone Idea, including intense competition and regulatory hurdles. The herd that once propelled the IPO’s popularity could not shield investors from the harsh realities of the industry, underscoring the risks associated with blindly following the crowd.

#4. Falling prey to hype

Hype in the context of IPOs is the amplified buzz and excitement generated by media coverage, market speculations, and the general sentiment surrounding a company’s public debut. It can create a bandwagon effect, enticing investors to join in based on the perceived potential for quick and substantial returns.

Why Falling for Hype is Hazardous:

  1. Overvaluation Concerns: Hype can lead to inflated valuations, where the market sentiment overshoots the intrinsic value of the company, posing risks of a market correction.
  2. Short-Term Focus: Investors driven by hype often prioritize short-term gains, neglecting the long-term sustainability and fundamentals of the company.

Real-Life Example: Reliance Power IPO (2008):

The Reliance Power IPO in 2008 serves as a wonderful illustration of the risks associated with succumbing to hype. Backed by the formidable Reliance brand and amidst tremendous media buzz, the IPO garnered unprecedented attention. Retail and institutional investors alike were drawn to the promise of participating in the growth story of one of India’s leading conglomerates.

However, post-listing, the stock faced significant challenges. The hype that fueled massive oversubscription did not shield investors from the subsequent market realities. The disconnect between the pre-IPO excitement and the post-listing performance highlighted the importance of distinguishing between genuine potential and exaggerated enthusiasm.

#5. Basing the decision on subscription data

Subscription data, which indicates the number of times shares offered in an IPO are applied for, can be a compelling metric. High oversubscription is often interpreted as a vote of confidence from investors, leading others to jump on the bandwagon in anticipation of potential gains.

The level of oversubscription is closely watched, and investors may be tempted to base their decisions solely on these numbers. However, this approach, while seemingly straightforward, comes with its own set of risks and potential pitfalls.

Why Relying on Subscription Data Can be Misleading:

  1. Quality vs. Quantity: High oversubscription doesn’t necessarily indicate the quality of demand. A large number of applications may come from retail investors seeking short-term gains, rather than a solid, long-term investor base.
  2. Market Conditions: Subscription data reflects demand at a specific point in time. Market conditions can change rapidly, and oversubscription may not be a reliable predictor of post-listing performance.

Real-Life Example: IndiGo IPO (2015):

The IndiGo IPO in 2015 serves as a noteworthy example. The aviation sector was riding high on optimism, and IndiGo, a prominent player, generated immense interest. The subscription data reflected this enthusiasm, with the IPO being heavily oversubscribed. Investors, influenced by the apparent demand, might have expected significant listing gains.

However, when the stock debuted on the market, the initial fervor did not translate into sustained performance. The IndiGo example sheds light on the nuanced relationship between subscription data and actual market outcomes.

#6. Going for big applications

The pursuit of sizeable returns often lures investors into opting for larger applications in IPOs. The rationale is clear – a larger investment could potentially lead to more significant profits upon listing. While the allure of a bigger stake is undeniable, this strategy comes with its own set of challenges and risks.

Investors, fueled by the desire for substantial gains, often opt for larger application sizes in the hope of securing a more significant allotment. The logic is straightforward – a higher allotment could translate into larger profits when the stock lists.

Challenges of Going Big:

  1. Allotment Uncertainties: Larger applications do not guarantee a proportionally larger allotment. The allotment process considers various factors, including the overall demand and regulatory guidelines.
  2. Market Fluctuations: The market conditions during the IPO period can influence allotments. Oversubscription may lead to a scenario where even large applications receive only a partial allotment.

Real-Life Example: SBI Cards IPO (2020):

The SBI Cards IPO in 2020 witnessed immense demand from investors. The optimism surrounding the IPO led many to apply for larger quantities, hoping to capitalize on the perceived success of the offering.

However, despite the high demand, many retail investors who went for substantial applications were not fully allotted, leading to unexpected outcomes.

#7. Ignoring the Red Herring Prospectus

the Red Herring Prospectus (RHP) stands as a comprehensive document that provides invaluable insights into the company’s operations, financial health, and future plans. Ignoring or underestimating the importance of the RHP can lead to misguided investment decisions and missed opportunities for due diligence.

The Red Herring Prospectus serves as a crucial informational blueprint for potential investors. It contains detailed information about the company’s business model, financial statements, risk factors, and the purpose of the IPO. Investors who overlook this document risk making decisions based on incomplete information.

Why Ignoring the RHP is Risky:

  1. Incomplete Understanding: The RHP provides a comprehensive understanding of the company’s operations, industry dynamics, and potential risks. Ignoring it leaves investors with an incomplete picture.
  2. Failure to Assess Risk Factors: The RHP outlines various risk factors associated with the company, including market risks, regulatory risks, and operational risks. Neglecting these factors can expose investors to unforeseen challenges.
  3. Missed Opportunity for Due Diligence: Thoroughly analyzing the RHP is a crucial step in the due diligence process. Investors who skip this step miss the opportunity to make informed investment decisions based on a complete understanding of the company’s fundamentals.

Real-Life Example: PNB Housing Finance IPO Controversy (2016):

The PNB Housing Finance IPO in 2016 became embroiled in controversy due to alleged discrepancies between the information presented in the RHP and the company’s actual financial health. Investors who overlooked or neglected to thoroughly analyze the RHP were blindsided by the post-listing challenges faced by the company, highlighting the perils of ignoring this vital document.

#8. Falling For Valuation Trap

Investors frequently face the challenge of determining whether an upcoming IPO is reasonably priced based on its valuation. The valuation trap occurs when investors are lured by seemingly attractive valuations without critically assessing the underlying fundamentals.

Risks of Falling for Valuation Trap:

  1. Overpaying for Growth: An attractive valuation may not always reflect a company’s growth potential accurately. Investors falling for the valuation trap might overpay for expected growth that fails to materialize.
  2. Ignoring Red Flags: Focusing solely on valuation may lead investors to overlook red flags related to the company’s financial health, management, or industry challenges.

Real-Life Example: Kingfisher Airlines IPO (2002):

The Kingfisher Airlines IPO in 2002 serves as a cautionary tale of falling for the valuation trap. The IPO generated significant investor interest, driven by the brand’s prominence and the enticing prospects of the aviation industry.

However, the company faced financial challenges post-IPO, revealing a misalignment between the perceived valuation and the company’s actual financial health.

#9. Failing to understand the business model

A business model is the blueprint that outlines how a company creates, delivers, and captures value. It encompasses revenue streams, cost structures, and the unique approach a company takes to gain a competitive edge.

Failing to grasp the intricacies of how a company generates revenue and sustains itself can lead to misguided investment decisions.

Risks of Failing to Understand the Business Model:

  1. Misjudging Profitability: A superficial understanding of a business model may lead to misjudging the company’s potential for profitability. Not all revenue streams are created equal, and some may be more sustainable than others.
  2. Overlooking Risk Factors: Every business model carries inherent risks. Failing to understand these risks can result in underestimating the challenges a company may face, impacting the investment’s overall risk-reward profile.

Real-Life Example: Coffee Day Enterprises Limited IPO (2015):

Coffee Day Enterprises, one of the largest coffee chains in India and the parent company of Café Coffee Day, went public with its IPO in October 2015. The IPO aimed to raise funds for business expansion and debt reduction.

However, the IPO faced challenges related to the company’s business model and financial structure.

Investors who may not have fully understood the company’s financial structure, dependence on a single business segment, and the challenges associated with high debt levels faced difficulties as the company’s stock experienced significant declines.

#10. Not planning your holding period

One crucial aspect that investors often overlook is planning their holding period. Failing to define a clear strategy regarding how long to hold the investment can lead to missed opportunities or unexpected challenges.

The holding period is the duration an investor intends to hold a particular investment before selling. In the context of IPOs, having a well-defined holding period is essential for aligning investment goals, managing expectations, and optimizing returns.

Risks of Not Planning the Holding Period:

  1. Short-Term Volatility Impact: IPOs often experience volatility in the initial trading period. Investors without a defined holding period may react impulsively to short-term price fluctuations, potentially missing out on long-term gains.
  2. Missed Long-Term Opportunities: Some IPOs may take time to realize their full potential. Not having a clear holding period may lead investors to exit prematurely, missing the opportunity for significant long-term returns.
  3. Unrealized Losses: Without a holding period plan, investors may hold onto underperforming stocks for too long, resulting in unrealized losses. Conversely, they might hastily sell high-potential stocks before they have a chance to mature.

Real-Life Example: IRCTC (Indian Railway Catering and Tourism Corporation) IPO (2019):

The IPO of IRCTC provides a compelling example of the importance of planning the holding period in the context of a government-owned company with a monopoly in its sector.

The stock’s post-listing volatility may have presented challenges for investors who did not have a clear plan for their holding period. Rapid price fluctuations could influence decision-making without a long-term perspective.

Also Read : All-time Biggest IPOs of India and their performance after listing

#11. Borrowing to apply

Investing in IPOs can be an enticing opportunity, and some investors may be tempted to borrow funds to amplify their investment in the hope of substantial returns. However, this strategy comes with significant risks and financial consequences.

Borrowing money to invest in IPOs is a form of leverage, where investors use borrowed funds to increase the size of their investment. The appeal lies in the potential for higher returns, especially if the IPO experiences significant price appreciation.

Risks and Consequences of Borrowing for IPOs:

  1. Interest Payments: Borrowed funds come with interest obligations. If the investment doesn’t perform as expected or experiences losses, investors still need to service the debt, adding financial strain.
  2. Margin Calls: If the value of the invested funds falls below a certain threshold (due to a decline in stock prices), investors may face margin calls, requiring them to either inject more funds or sell assets at potentially unfavorable prices.

How to Avoid these Common IPO Mistakes

Avoiding common IPO mistakes requires a combination of thorough research, disciplined decision-making, and a strategic approach to investing. Here are guidelines to help investors steer clear of the mentioned IPO mistakes:

  1. Paying Too Much Attention to the Grey Market:
    • Guideline: Rely on fundamental analysis instead of relying solely on grey market premiums.
    • Action Steps: Evaluate the company’s financials, industry position, and growth prospects. Grey market premiums can be speculative and may not accurately reflect the company’s true value.
  2. Following the Herd:
    • Guideline: Conduct independent research and make decisions based on your investment goals.
    • Action Steps: Avoid making investment decisions solely because others are doing the same. Analyze the IPO independently and consider your risk tolerance and financial objectives.
  3. Falling Prey to Hype:
    • Guideline: Separate hype from fundamentals.
    • Action Steps: Scrutinize the company’s financial health, business model, and competitive landscape. Be cautious of excessive media hype and focus on the underlying fundamentals.
  4. Basing Decisions on Subscription Data:
    • Guideline: Use subscription data as one of many factors in decision-making.
    • Action Steps: Consider subscription data along with other factors like company fundamentals and market conditions. High subscription numbers don’t guarantee post-listing success.
  5. Going for Big Applications:
    • Guideline: Allocate funds judiciously and avoid overcommitting.
    • Action Steps: Assess your risk tolerance and allocate funds based on a well-defined investment strategy. Avoid investing more than you can afford to lose.
  6. Ignoring the Red Herring Prospectus:
    • Guideline: Thoroughly review the Red Herring Prospectus (RHP).
    • Action Steps: The RHP contains essential information about the company’s business, risks, and financials. Ignoring it can lead to uninformed investment decisions.
  7. Investing for Listing Gains:
    • Guideline: Focus on the company’s long-term potential.
    • Action Steps: Evaluate the company’s fundamentals and growth prospects beyond listing gains. A sustainable business model is key to long-term success.
  8. Falling for Valuation Trap:
    • Guideline: Assess valuation in conjunction with other factors.
    • Action Steps: Don’t solely rely on valuation metrics. Consider the company’s growth potential, competitive position, and industry outlook.
  9. Failing to Understand the Business Model:
    • Guideline: Conduct comprehensive due diligence on the business model.
    • Action Steps: Understand how the company generates revenue, its competitive advantages, and potential risks. A clear understanding is crucial for informed decision-making.
  10. Not Planning Your Holding Period:
    • Guideline: Define a clear holding strategy aligned with your goals.
    • Action Steps: Determine whether you are investing for the short or long term. Having a predefined holding period helps manage expectations and aligns with your overall investment strategy.
  11. Borrowing to Apply
    • Guideline: Avoid leveraging investments, especially in volatile IPO markets.
    • Action Steps: Invest only what you can afford to lose. Borrowing to invest increases risk and can lead to financial stress in the event of market downturns

Conclusion

In IPO investments, steer clear of common mistakes for success. Avoid following the crowd or getting caught up in hype; stick to disciplined, independent decisions.

Thorough research is crucial—understand the company’s business model, financial health, and industry trends. Don’t be swayed by short-term gains; focus on long-term potential. Manage risks wisely; don’t borrow funds for investments.

Define a clear holding period aligned with your goals, and stay resilient in the face of market volatility. Learning from past mistakes, investors can navigate the IPO terrain with caution, making informed decisions for a more secure investment journey.

If you are beginner to IPOs, We suggest you to check out What is an IPO which covers basics of IPOs in India in Detail.

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