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The Dynamics Of Primary Markets

“In the short run, the market is a voting machine but in the long run, it is a weighing machine”

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Last week, a former colleague called me to discuss the proposed US IPO of the real estate / office space company WeWork. We were discussing the dot-com boom of the late 1990s, when the ‘burn rate’ i.e. the rate at which companies used up cash raised from investors was more important than actual positive cash flows or even positive operating margins.

In 1996, US Federal Reserve Chairman Alan Greenspan had expressed worry at this “irrational exuberance”, while since 1997, renowned investor  Howard Marks was calling for a market crash given the exuberant valuations based on eyeballs and burn rates. In the short term, as dot-com entrepreneurs took their companies public, there was frenzied wealth creation, and a new breed of investors dismissed sober warnings of an unsustainable bubble cavalierly as “this time it’s different”.

As Sir John Templeton, legendary investor and value investing proponent remarked decisively in 1993, “The four most expensive words in the English language are: ‘This Time It’s Different.’”

History may not repeat itself, but it often rhymes. For investors, the sobering lesson is that the markets always revert to fundamentals after every excess and every bubble, as well as after every period of recession and depression.

As the dot-com bubble peaked with the March 2000 Nasdaq Composite Index at level of 5048, the “This Time It’s Different due to the Internet” chorus became a derisive laugh at market greats: like Warren Buffett who underperformed as he stayed away from the new economy stocks; like Julian Robertson who returned money to his investors and shut down his fund calling for an imminent crash and like John C. Bogle, who predicted a lost decade of zero returns in the US markets from 2000 to 2010.

In stark contrast to this was a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead in the US markets. Their answers averaged 19 per cent. That, for sure, was an irrational expectation.

From 5048 in March 2000, the Nasdaq crashed to 1114 in October 2002, and reached 5048 again only in July 2015. The ten-year returns from 2000 to 2010 were - 55 per cent. Over 15 years the Nasdaq gave no returns. John Bogle was right.

The big lesson for investors is that markets are cyclical and are given to excesses on both the higher side and the lower side. Primary markets, which see the raising of funds by companies through initial public offerings or IPOs are affected by these cycles and contribute to them as well. In fact, investors fear “market killing IPOs” that act as the needle that deflates market bubbles. WeWork that had a private market valuation of $47 billion in January 2019 is now rumoured to be looking at an IPO valuation of $15 billion or less. The post-IPO falls in the listings of Uber and Lyft have reduced investors’ appetite for loss- making new economy companies being valued at stratospheric levels based on hope.

History give us some insights. Amazon had its IPO on May 15, 1997 at $18 per share. In 1996, Amazon grew its revenue to $15.75 million, or a 2,982 percent growth over 1995. Its losses grew to $5.78 million. By the widely respected Rule of 40 — that a company’s growth rate plus its profit margin should equal 40 or more — Amazon was destined for greatness. That was a pointer to how the company raised its market value from $438 million in 1997 to todays $900 billion, after falling 10 per cent in the last few months.

But for every Amazon, there are thousands of failed startups and failed cases of penny stocks.
So what are the secrets to the success of an IPO? We must remember that the IPO is an important milestone in the journey of a company, but it is a milestone and not the end in itself. The overall position of the market cycle from extreme bullish to extreme bearish determines the top down attractiveness of an IPO. In the post dot-com bust era or during the global financial crisis of 2008, IPOs would have found it very difficult to get subscribed and to get reasonable valuations.

Following from the state of the economy and the market cycle is the state of the particular sector and its attractiveness. The infrastructure boom in India of 2003-2008 saw stellar returns for all connected to this sector. It ended badly as huge sums were raised in IPOs by dubious companies which are now penny stocks or sitting in bankruptcy proceedings in the NCLT. The professional investors were as poor at market timing, as many infrastructure focused mutual fund schemes were launched at the peak of the market and lost huge value for investors thereafter as the inevitable correction happened in 2009. We have seen 10 years of underperformance from all infrastructure related stocks and the funders of these, largely the public sector banks.

The next factor that is critical is the company’s financials and at what value are those financials being offered to investors. A connected factor is who is selling? If it is an offer for sale from PE/VC investors looking for an exit, there is a good chance that there is not much money left on the table for public investors. The pedigree of the leadership of the company is another determinant of the success of the IPO.

Then we come to the actual addressable market that the company serves, the competitive intensity and the historical growth rate of the company versus the growth in the market.

Finally, it is critical to look at growth potential and financial metrics like margins, fixed and variable costs, debt levels and return on equity. The proposed use of the IPO proceeds is also important, especially for highly indebted companies.

In summary, from the macro conditions to the company specific metrics, a whole range of success factors are at work in the success of an IPO. But the science of this success is not infallible, so there is art as well involved in the success. No one formula can guarantee success, but fulfilment of the formula is a necessary starting point.

Company health, good governance, cash flow discipline and minority share holder protection are difficult to gauge for newly listing companies, but are critical factors behind the success of the IPO over the long term.

Two recent success cases of IPOs in the Indian market, Affle and IndiaMart, provide good insights. To be clear, this is not investment advice nor am I an investor in either of these companies at present.

The 86 times oversubscription to Affle IPO was a pointer to the demand for this mobile marketing company that offered a pedigreed promoter base in Microsoft, NTT DoCoMo’s D2C Inc. and Itochu Corp, a vast addressable market, a huge pool of 202 crore consumer profiles spread globally, good three-year growth CAGR of 34 per cent and 610 per cent in revenues and PAT over FY 17-19. The Rule of 40 was handsomely met and the RONW of 67 per cent was an added attraction for a rare, profitable new economy company. On listing day the shares went up 25 per cent and at present are 20 per cent higher than the offer price of Rs 745.

IndiaMart similarly recently had a 36 times over subscription to its IPO with a strong post-IPO performance from an IPO price of Rs 973 to a September 13, 2019 closing price of Rs 1,618. A 70 per cent market share, the booming online marketplace model, network effects and a possible takeover target premium made this a successful IPO.

These two IPOs were successful at a time of global and domestic stock markets underperformance and high volatility. These are valuable lessons for investors to internalise. Fundamentally, strong stories with pedigree, revenue growth, margins and potential will do well despite the prevailing sentiments being negative.

As the teacher of Buffett, Benjamin Graham put it: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Fundamentals take over ultimately, but in the short run, sentiments, fads, momentum and “This time it’s different” fetishes dominate.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

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Ajay Bagga

Bagga is a stock market expert

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