Thursday, March 19, 2015

Against all odds: IPOs and why you should fear them

"It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors)."
- Warren Buffet

Typically an investment bank (on wall street, dalal street, or other financial hubs) will make anywhere from 3% to 7% of IPO proceeds as fees. Brokerage fees are typically very small (below 0.15%). This should make it very clear that financial intermediaries make the bulk of the money via initial or follow on public offerings by listed companies. When the bank is going to get such a large percentage of the proceeds as fees they are naturally motivated to drive the price up as much as possible. This is why many a seasoned investor will tell you not to buy into IPOs as most of them are overpriced by the banks via their massive marketing and sales channels.

The business of investment banks is a highly competitive one. They typically operate like an oligopoly. The prices are typically fixed within a narrow band. Most banks prefer to run IPOs because they make more than their net interest margin of a year in just a few months with very few man hours of effort. The differentiation between the banks is low and typically deals get done based on who was most friendly with the company’s board. Lots of IPOs are syndicated with various percentages with various banks.

This said most IPOs are priced relative to the market. So if the absolute market index P/E is at an all time low the bank is not going to be able to price the IPO like it could when the index P/E was at an all time high. However, the sales force of investment banks is the best in the world. Imagine how hard it would be to sell a story? The equity sales desks have the best sales training known to man and they use it. If you see a stock salesman at work it is very scary – they can just on the phone make less knowledgeable buyers buy things they should never be buying.

So the bottom line is if you are going to buy IPOs know that you are paying a very large brokerage fee – probably at least 20x the normal fee. It is also probably inflated out of proportion given the massive sales force and advertising behind it. At this point if you still think it is underpriced and have good research to back it some IPO investments can make money but the odds are stacked against you! IPO investing to me sounds like the Phil Collins song “Against all odds”.