Sucheta Dalal :Grading Game
Sucheta Dalal

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Grading Game  

September 9, 2009



An advertising campaign by the National Securities Depository Limited (NSDL) in August proclaimed that it has one crore demat accounts. NSDL accounts for 80% market share. India officially claims an investor population of two crore. This number, which includes a big chunk of multiple account-holders, reflects the sad state of retail investor participation in the market. But media reports, quoting the depository officials, claim that a few hundred thousand retail investors are opening demat accounts every month mainly to subscribe to initial public offerings (IPOs).


Now that the IPO market has revived, shady and greedy realty, retail and communications companies are dusting down IPO documents prepared during the 2007 bull market and getting set to float over-priced issues, once again. A small fly in the ointment is the IPO grading process mandated by SEBI. Contrary to what market intermediaries claim, and the media dutifully reports, investors do seem to look at IPO gradings. That worries promoters and investment bankers who expect to sell public offerings on the basis of hyped-up advertising. Is it any wonder then that the first sign of revival in the IPO market has led to a rash of reports about how IPO gradings don’t work.


Consider this ‘research report’ by SMC Global. It analysed 63 IPOs between 2007 and 2009 and concludes: "IPOs in all grades faced substantial wealth erosion in the range of 20% to 70% irrespective of their grading." It does not mention that overall decline in stock prices was more than 20% in that period. The Sensex declined from 21,000 in January 2008 to 15,551 on 1 September 2009.


SMC’s next observation is that nine out of 10 IPOs with Grade 4 (the highest) are trading below their issue price and under-performed those with Grades 2 and 3. So SMC Capital suggests that IPO gradings failed to guide investors and SEBI must consider scrapping them. Here is what SMC ignores in its own study. The 13 IPOs with the lowest grading declined a whopping 70%. In comparison, the hyped-up IPOs with the highest grading declined 40%. IPO returns in the highest graded category were probably skewed by one company, Reliance Power, which tumbled from its offer price of Rs450 to Rs160 on
1st September.


If IPOs with the lowest grading have declined more precipitously (70%), the conclusion should be that IPO gradings are, indeed, a fairly effective guide, even if they do not take price into account. Even Austral Coke, where SEBI discovered fraudulent diversion of IPO proceeds, had a low Grade 2 and the report specifically warned that grading is "constrained by risks associated with proposed deployment of funds."


A data aggregator, who has steadily campaigned against IPO gradings, claims that investors have completely ignored IPO grading. But there is plenty of evidence to the contrary. The Bombay Stock Exchange’s (BSE) first product under the new CEO, Madhu Kannan, is the BSE IPO Index. Although its commercial utility is not quite clear, it will ensure that post-IPO performance will be tracked in a systematic manner, at least for academic purposes.


A couple of websites such as and have also begun to track IPO gradings and add value to them. Since market intermediaries are against IPO grading, only genuine investor/speculator groups would want to compile this data in a systematic manner. This, again, does not indicate that investors are ignoring gradings.

The question that remains is: Should IPO gradings factor in market size? The answer is no. Clearly, IPOs by large, established groups attract higher retail participation and better liquidity (as pointed out in a research paper by Vijay Marisetty and Saikat Deb that analysed 159 IPOs between 2006 and 2008); but that is a result of their size and advertising budget. The more significant finding is that IPOs with the lowest grade showed a significantly sharper decline; this is an important signal for retail investors.

-- Sucheta Dalal