Many of you who regularly follow my column would know that I generally don’t consider IPOs to be attractive investments. Then why this sudden volte-face you may ask? Well…usually IPOs come with baggage: either a high price, or low quality or both. Recently, I was listening to a speech (on YouTube) by Charlie Munger (the not so popular side kick of the billionaire investor Warren Buffett) to students at the University of Southern California (USC). In the course of his speech he mentioned about a particular aspect of human nature that he felt was a big danger in life: intense ideology and the resulting lack of open mindedness to examine disconfirming evidence. So, while I may still be skeptical about IPOs, what I have uncovered is disconfirming evidence - a rare worthy IPO (issue opening Sep 7th, 2009)

OIL is a company that’s been around for 50 years. It is the second largest public sector oil and gas producer after ONGC (but only 10% the size of ONGC). Over the last nine years the company has generated an average return on capital in excess of 20%. The company has almost no debt (loans). It has steadily paid increasing dividends year on year to its investor – the Government of India (till date). Going by the long-term track record, the company has demonstrated that it is doing very well financially.

Of course there is a huge macro risk – which is the price of oil. If oil price crashes and stays below $30, it may adversely impact profitability of oil production companies. Currently oil price is around $70. There are numerous highly intelligent people making a living out of predicting the price of oil. But even those who get it right the first time, trip when they try their luck again (remember the famous Indian research analyst who first correctly predicted oil will touch $100, but later upgraded the price target to $200, only to see it fall even below his first prediction). Although there are many alternative fuels under development, many of these are prohibitively expensive or inaccessible. They are unlikely to impact the demand for oil – atleast not over the next decade. Infact, oil consumption will continue to increase, as it has done over the last many decades – but may be slower. That’s on the demand side. On the supply side, everyone believes the world is running out of oil– so as long as this fundamental belief is not disproved, the price of oil can be reasonably expected to stay at current levels or move up over the next decade. The same argument can be extended for gas.

The second macro risk is the subsidy regime of our Government, which currently mandates PSU oil-producing companies in India to share the burden of selling fuel at below market price. Despite this, PSU oil and gas production companies in India, including OIL, have managed to maintain their high profitability in the past. So I think we can assume that as long as the Communists don’t come to power, oil-manufacturing companies can maintain their profitability.

Now, let’s get to the pricing of fresh shares in OIL that are being offered in the IPO. Firstly, only a small portion of fresh stock is going to be issued in the IPO - 11% of post issue total shares to be precise (I am not counting the portion of existing shares (10%) that would be sold by Government of India to the Oil marketing companies – namely IOC, HPCL, BPCL). At the higher end of the price band (Rs 1050 per share) at which fresh shares in the company are being offered, the post issue Enterprise Value of the company (approx. 25,000 crores) will be around 2.1 times the total capital in the company’s balance sheet i.e 2.1 times the ‘book value’ of total assets (post issue).

Book value of assets refers to what you would get, if you were to strip the company into parts and sell them chunk-by-chunk. In other words, ‘1 time book-value of assets’, is the bare minimum that the company would be worth, if it were to shut down tomorrow. We all know this is not going to happen. I think this company is going to continue to exist for many years to come and most likely continue to earn a return of 20% + on the capital that it uses. FYI this is more than twice the passive return generated by money in a bank FD. For this superior return generating potential, the IPO price is valuing the company at 110% premium to the value of assets in the company. This, according to me, is at a discount to the true fair value of the company. In my opinion, this IPO provides an opportune time to get into a strong company and compound your wealth for many years to come. May be that’s a reason why the Government is diluting only a small portion of its stake at this point.

Does this mean post listing the stock price of OIL will never come down below its issue price? No.

Would there be an opportunity, in the near future, to buy this stock cheaper? May be.

Is there risk of ‘permanent’ loss of capital if you invest at current price being offered in IPO? No.

What is the long-term average return that you can expect if you invest at the IPO price? 15%-20% p.a.

Please note: the standard disclaimer applicable to any investment advice applies here too. And…please don’t go bonkers and invest 100% of your net-worth in this. For the overzealous types, here’s my adaptation of Mr. Narayana Murthy’s famous saying: In God we trust…in stocks we better diversify.

Source : http://www.shyamscolumn.com/