P N Vijay explains why it was an Omi(cro)nous black Friday sale of stocks on Dalal Street

02:30 AM Dec 01, 2021 | P N Vijay

It was not Amazon or Flipkart selling but investors -- big and small -- from all over the world who were selling shares in the Indian stock exchanges on Friday -- the proverbial ‘opening’ day for the shopping season in the West. Shell-shocked investors saw their wealth melt away in minutes, as the screens were plunged in a sea of red.

The immediate reason was the fear that Omicron - the latest variant of the coronavirus - which showed up first in Botswana in Africa a few days ago may spread, conjuring up the gory spectre of another wave sweeping the world. If that happens, it will have very serious consequences. While right now there is no indication that the variant is spreading, people are worried about the possibility, and many have hit the road, running to get to the exit door first.


Last straw


The fear of Omicron was not the sole reason but the “last straw on the camel’s back”. The market had turned weak in the previous few days on account of the disastrous debut of Paytm, whose shares were listed for trading after India’s biggest ever initial public offering (IPO) of shares to retail investors. Research reports from top broking firms saying that Paytm was still making huge losses and its business was under considerable competitive pressure led to panic among investors.

Hitherto, in the last one year, retail investors had made big gains by buying shares at the time of the IPO and selling the shares on the stock exchange immediately upon listing. So good was the profit that some investors even obtained loans from banks so that they could buy more shares. For people who bought Paytm shares using borrowed funds, the losses were consequently even higher. No wonder it was a black Friday on the Indian markets last week.

Startups in the red

This event has set in motion a huge argument on whether start-up companies which are still making losses should be allowed to approach the stock market and raise capital from retail investors who are not experts in analysing the value of shares. Startups have, without doubt, been a spectacular success in India. They have used technology and digitalised business and trade in a big way. We use Indian start-ups for almost everything; Paytm and PhonePe for paying the street vendor, Big Basket to order groceries, Byjus for the kid’s education, Swiggy and Zomato for ordering food, makemytrip for our travel bookings… the list is endless. In fact, the last decade could be called the decade of startups.

Then why this fuss about the fiasco of Paytm shares? To understand this, one needs to understand how these startups have been funded in the first place. Startups are founded by smart young people from leading universities like IITs, who are rich in ideas and ambition but have no capital. The startups raise money from investors who are private equity (PE) and venture capital (VC) firms. Many of these are in the US though in India also, the PE/VC industry is active and growing.

Private equity, venture capital firms

These PE/VCs are somewhat like mutual funds, that raise money from rich investors who have an appetite for risk. When they invest, it is common for these PE/VCs to look for a return upwards of 40 per cent per annum and above and an exit from their investment in five years. This exit is important for them because they have raised money for five years from their investors and need to give them back their money within this period. This type of return is also important for the PE/VCs because investment in startups is very risky and only less than half the startups succeed. The rest fold up, leading to losses for the investors.

The way startups work is that they spend huge amounts of money in the first few years in perfecting their product and developing the market. This is called the ‘cash burn stage’. In fact, a considerable portion of the capital raised is used just to finance the losses. It takes them a long time to get the market share and the pricing power and to become profitable. Often, investors who have invested huge amounts are not willing to wait for this to happen and apply considerable pressure on the founders to give them an exit. Under pressure from such investors, the founders go public and sell the shares of the PE/VCs to small investors, who finally end up buying the shares at exorbitant prices; sometimes at 100 times the price paid by PE/VC investors.

Greater fools theory

Here, we have a perfect example of the greater fools theory which goes something like this: A invests Rs 10 for Rs 10 share. One year later, B invests in the first-round funding at Rs 50. Three years later, C invests in the second round at Rs 200. Five years later, an IPO is done at Rs 2,000 to housewives and office clerks. A, B and C sell 80 per cent of their shares at Rs 2,000. The share falls to 1500. Retail investors lose their savings while A, B and C laugh all the way to the bank.

The irony about listing startups in the market is that traditional investors, on entering the market, look for some dividends and some capital appreciation. They want ‘value’ in the companies they buy. But these new-age startups will not yield dividends for a long time.

What is the way forward? There are some who say, ‘Do nothing’ and let caveat emptor (buyer beware) be the rule. One way is to exercise some control on the manner in which such loss-making companies can enter the stock market and issue shares to small investors. But that will go against the grain of all the reforms we have done in capital markets last 30 years and released the market from government control. Another is for investors to get more educated and make informed decisions and not throw their hard-earned money in the hope of making a quick buck. The jury is still out.

­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­The writer is an investment banker and a political commentator. His twitter handle is @pnvijay

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