Investors guide to equitable information : Economic Times: 28th October 2010

grade is not only a recommendation to buy but only an evaluation of the fundamentals of a company going in for an initial public offering.


When the idea of equity grading was first proposed in the late 1990s,it was dismissed by critics as being a good theoretical,though fantastical,concept.

The purpose of rating equities was to provide the potential investor with a view if a company was fundamentally sound.

More than a decade down the line,IPO grading has caught on and sounds a capital idea in a market that is characterised by information asymmetry that becomes even more acute given the imperfections in the market.What exactly are we talking of

The capital market is booming today,and since a rising stock index is a prerequisite for buoyancy in the primary market,this is the right time for companies to raise money.

Prior to reforms,shares had to be priced according to a preset formula of the Controller of Capital Issues.

With reforms,this institution was abolished and free pricing became the norm as innovations such as book-building with price discovery invoked within a band becoming popular.

While this is good in a market economy where companies could get the premium that the fundamentals demanded,many fly-by-night operators raised money to later disappear or get into sick mode,leaving the investors holding junk paper.

The situation is not dissimilar to the information system in the second-hand car market lemons where the issuer knows how good the company is but the investor does not have much to go on.

This is the idea behind the concept of IPO grading that the creditrating agencies have offered to investors.

The grading is based on a thorough study of fundamentals of the company,its financials,prospects,promoters,industry profile,etc.

The grades,between 1 and 5,tell the investor about the fundamentals of the company seen at this level.

This is of particular importance for companies going for an initial public offering (IPO) where the public has limited knowledge of the unit.

The information is drawn from documents filed with the regulator.

But a layman cannot really make much of this bundle of literature.

Hence,a credit rating agency bridges this information gap with a grading.

However,a grade is not a recommendation to buy but only an evaluation of the fundamentals of a company going in for an IPO.

The problem today is that it has been interpreted as being a recommendation to purchase a security and,hence,the evaluation of the grading has been juxtaposed with the market price.

This is a typical manifestation of investor frailty where one ends up interpreting any view as an advice.

This would not be the right way to go about it as markets move up and down based on a mlange of factors that often may not have a bearing on the performance of the company.

Therefore,it has been taken to be analogous to the concept of equity research done by investment banks and brokers who give a trading call: buy or sell.

The debate today is that if the IPO grading system is not going to be tested against the market,then does it serve any purpose.

It is pertinent to note that once we move away from the scheme of intermediation and enter the market,the transition is into the world of unknown where the investor only gets to see what the issuers want you to see.

In case of a bank,one puts money as a deposit.

The bank has the skills to bridge the information gap and has the risk-taking ability to actually lend onwards to the borrower.

The cost of intermediation is high at times,but that is the price that the ultimate saver pays for security.

Once in the market,the risk and returns are borne by the investor.

This is where the credit-rating agency comes into the frame.

The rating given for debt or the grading to an IPO is an evaluation of either the servicing ability of the issuer or the fundamental strength of the company.

This view,which is not an advise,is given independently by a specialist body and,hence,provides an additional input to be taken by the investor before putting in money.

It is not a certification of the price being right or not.

Now,is this product a useful one This can be examined from both the ends.

Based on counter-intuitive reasoning,that companies are going for grading and not complaining given that it is mandatory,meaning they see value in the exercise.

From the investors point of view,she gets the analysis in one number and can use this to judge if the pricing is right as the grading is done before the price is fixed.

Also,the test of the grading is not in the market price but the overall performance of the company;as prices vary depending on extraneous conditions.

And the market is the final judge of the agency that has its reputation at stake.

Therefore,any evaluation of the IPO grading process should work on the premise that it is the grading of the fundamentals that is done even before the price is fixed by the issuer.

Else,one could come to an erroneous conclusion if it is taken to be an investment advisory service.

To quote Ayn Rand,Contradictions do not exist.

Whenever you think you are facing a contradiction,check your premises.

You will find that one of them is wrong. This should be the spirit behind viewing such a product.