Tuesday 11 November 2008

Going back to the basics of primary market

With markets being cloudy and showing little sign of hope of recovery in near future, this is the right time for ‘foolish investors’ to tune up their doubts on two hot picks of the primary markets, New Fund Offer’s (NFO) and Initial Public Offering (IPO).

‘Foolish investors’ here refers to majority of the investors who put their money in stocks, IPOs and mutual fund on plain tips and rumors and not more often on research which is the foremost requirement.

In fact, many do their required primary research after parking their money in the investment avenue.

IPO is a generally used term for when the company has decided to go public at large by offering its ownership interest.

NFO is a security offering in which an investor may purchase units of a closed-end mutual fund. A new fund offer occurs when a mutual fund is launched, allowing the firm to raise capital for purchasing securities.

(Definition source: Investopedia)

IPO’s and NFO’s are often confused to be same as both represent attempts to raise capital for carrying out further operations.

However, there are striking differences between both of them.

Fundamentals:
IPO is an offering made by an enterprise wherein the promoters sell their stake in the company to public at large in order to raise capital.

Meanwhile, NFO is a first time offering by mutual funds which are investment vehicles that collect money from a large group of investors, pool it together and invest it in various securities in line with their objective.

Based on the principle of ‘strength of numbers’ they prove to be a useful alternative to direct investments by small investors by providing ownership at minimum investment.

Reward/Ownership:

When you subscribe to an IPO in a predetermined bid lot size and price band (process explained below) you tend to get ownership interest in that particular company depending on the final allotment.

Each share you own represents your part of ownership in the company.

However, if you invest in an NFO (or as a matter of fact in any mutual fund) you acquire units of the particular fund and thus indirectly holding in many companies.

But the units you acquire are limited to your invested amount and the Net Asset Value (NAV).

NAV indicates the intrinsic worth of a scheme. It is nothing but per worth of each unit that investors hold.

Suppose, if on July 21, 2008 you want to invest in an IT company with a price band 140-150 and minimum bid quantity of 40, you would have to at least shell out Rs 6,000 ( 40 min bid quantity*150 the cap price)

On the other hand if you had invested the same amount in an NFO of X fund which specializes investing in IT companies, you would balance out your exposure in various companies instead of having single exposure in an IPO.

Pricing:

An IPO today most often is priced based on a book building process (100% or 75%) in which the company issuing the shares comes up with a price band decided together by book lead running managers and the companies.

The lowest price is referred to as the floor and the highest, the cap.

For example if the price band is Rs 90-Rs 105 say, Rs 90 is called the floor price while Rs 105 is called as the cap price.

Bids are then invited for the shares. Each investor states how many shares he/she wants and what he/she is willing to pay for those shares (depending on the price band).

The actual price is then discovered based on these bids, the sizes of which are pre decided.

NFO’s are often heavily advertized as being priced `at-par` when they hit the markets. The pricing can be illustrated as follows:

Suppose you have Rs 1,000 to invest in a NFO having a face value of Rs 10 and a Net Asset Value (NAV) of Rs 100.

Considering the above facts, you ought to get 100 units. Let’s say, the fund invests all the said money in a company A which buys 10 shares at Rs 150 each and after a year, the price of each share reaches Rs 200.

The NAV of your units would be: 200 per share *10 shares/100 units = Rs 20

Thus the value of your units would be Rs 20* 100 = Rs 2,000

Thus, IPO and NFO are instruments of primary market that give investors opportunities to acquire the offering first hand.

While company’s sell their stake in an IPO, NFO is an instrument wherein the fund house collects its corpus money from the investor contribution itself.

However, NFO lacks the IPO edge, which gives a chance to earn instant premium on investment bearing in mind the market conditions.


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Source: Reuters

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DISCLAIMER: The author is not a registered stockbroker nor a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity, index or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. The author recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and that you confirm the facts on your own before making important investment commitments.