Pump and Dump schemes are as old as history. But how do they work and how can investors protect themselves?
Pump and Dump Schemes Definition
Pump and dump (P&D) is a form of securities fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements (pump), in order to sell the cheaply purchased stock at a higher price (dump).
Once the operators of the scheme “dump” (sell) their overvalued shares, the price falls and investors lose their money.
Lessons from the intelligent investor
Today, I had the pleasure of delving into the pages of “The Intelligent Investor,” a timeless tome penned by none other than Benjamin Graham.
This literary gem is a veritable treasure trove of knowledge, expounding upon the art of Value Investing – the art of procuring shares in a company for less than their intrinsic worth.
Yet, the book’s offerings do not cease there. Among its chapters lie a plethora of investment approaches, sage advice, cunning strategies, and insightful discourse on diverse portfolios and investor archetypes.
Allow me to regale you with my findings, particularly a chapter of paramount importance titled ‘Portfolio of an Enterprising Investor,’ nestled on page 133.
This chapter lays bare the principles guiding an audacious investor’s path, urging them to sidestep perils that might lead them into the clutches of bankruptcy or speculative ventures.
Embedded within this chapter is a segment where Graham artfully unfurls the notion of vigilance and meticulous evaluation when confronted with new issues.
The term ‘New Issue’ is a veiled reference to Initial Public Offerings (IPOs), and Graham does not mince words as he lays bare the perils of investing in them without due diligence.
He pens two cardinal reasons for this cautious approach: firstly, new issues are often laced with persuasive marketing tactics, and secondly, they are often floated in “favorable market conditions” – a euphemism hinting at circumstances more favorable for the issuer and less so for the acquirer.
Pump and Dump Schemes always follow the same principle, first the pump, then the dump.
The Mechanism of Pump and Dump Schemes
(This encounter in ‘The Intelligent Investor’ piqued my curiosity, leaving me yearning for deeper comprehension regarding the perilous nature of new issues. Subsequently, I embarked on an investigative journey, unearthing insights about IPO mechanics, leading me to a resolute conclusion: engaging with IPOs sans due diligence is a perilous endeavor. Join me as I shed light on the shadows, elucidating why this can transmute into a dire choice if approached without circumspection.)
Unpacking the Enigma
In simpler terms, the crux of the matter lies in the fact that a considerable chunk of IPOs primarily benefits the early birds – the likes of venture capitalists and investment bankers who orchestrate the IPO launch through the underwriting process. Meanwhile, retail investors, the common folk like you and me, often find ourselves on the losing side of this equation. These overhyped IPOs are presented to retail investors at inflated prices during times that favor the seller rather than the buyer. The motives behind this are two-fold: firstly, salespersons stoke excitement and frenzy among retail investors, touting the prospect of swift gains. As a reward, these intermediaries are compensated with commissions from the company for every additional application they generate for the IPO.
However, when the curtains rise and the IPO takes center stage, what often unfolds is a scenario where retail investors face losses rather than gains. The reason for this disillusionment is the susceptibility of IPOs to the notorious “Pump and Dump” tactics.
Deconstructing the Pump and Dump Mechanism
In the intricate dance of the pump-and-dump scheme, the promoters of private firms leverage venture capitalists and investment bankers to inflate the IPO valuation during the pre-IPO phase. The pre-IPO phase encompasses the period leading up to the IPO launch – a time characterized by efforts to enhance the firm’s valuation. Early-stage investors, which include venture capitalists, investment bankers, financial institutions, and select influencers, play a pivotal role in this phase.
During this preparatory phase, the private company maneuvers through several rounds of funding, each round contributing to its valuation incrementally. This escalating valuation attracts additional investors, further fueling the company’s worth. When the valuation peaks, it’s time for the venture capitalists to make their exit, cashing in on their profits garnered during the funding rounds. This is because each funding round not only bolsters the firm’s valuation but also the capital invested by venture capitalists.
Upon the IPO’s public listing, venture capitalists initiate a sell-off, triggering a decline in the stock price of the newly listed entity. Unfortunately, the collateral damage falls upon retail investors, while the venture capitalists and other early-stage investors enjoy their spoils.
Adding a twist to the tale, investment bankers, despite being privy to this intricate dance behind the scenes, lend their credibility to these private companies. The higher the valuation of a firm they assist in launching an IPO, the more substantial their underwriting fees – often ranging from 3.5% to 7.0% of the IPO’s gross profits.
This serves as a blueprint of the pump-and-dump game, wherein early-stage investors bask in the light of success while retail investors are left grappling with the shadows of losses.
Pump and Dump Schemes among IPOs
The IPO arena serves as a fertile ground for pump-and-dump schemes. An illustrative case is the ill-fated IPO of Paytm – a loss-making entity that aimed to raise a staggering Rs. 18,300 crore from the public, offering a 10% stake in return.
This IPO, the second-largest in India’s history, garnered significant attention. However, behind the scenes, the valuation narrative told a different story. The pre-IPO valuation stood at a mere Rs. 1.6 crore, while post-public funding, it catapulted to a colossal Rs. 1.4 lakh crore.
As the IPO hit the market, venture capitalists began their selloff spree, and the market value plummeted to below Rs. 45,000 crore. On the day of listing, retail investors were dealt a staggering blow, enduring losses exceeding Rs. 460 crore. In the aftermath, it was clear that the IPO’s fate had been decided long before the public’s engagement.
This vignette serves as a somber reminder that retail investors are often the casualties of IPO machinations. As such, prudence dictates a cautious approach, demanding rigorous scrutiny of each IPO. The Paytm incident merely scratches the surface; similar tales of woe can be woven around IPOs like Zomato, Nykaa, Reliance Power, Car Trade Tech, and more.
The Intelligent Investor
This particular chapter from “The Intelligent Investor” ignited a fervent curiosity within me, prompting an exhaustive exploration of IPO dynamics.
It’s but one instance among many within the book that kindles the flames of interest while acting as a guiding compass along the intricate pathways of investment. In its entirety, “The Intelligent Investor” stands as an indispensable tome, enriching readers with a nuanced understanding of investment concepts and strategies.
Nestled within the pages of this masterpiece, readers glean the art of appraising a company’s value – a tool enabling them to discern if a stock is priced above or below its intrinsic worth.
Stocks themselves unveil their mysteries, with the text unraveling the mechanics that animate them. Diversification, a bedrock principle for managing risk, is dissected, while the distinction between investment and speculation is etched into the reader’s consciousness. Thought-provoking inquiries await aspiring investors, steering them toward sound decision-making.
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