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Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing

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par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010

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II-2-4\ Underpricing as a substitute of marketing expenditures:

Habib and Ljungqvist (2001) argue that underpricing is a substitute for costly marketing expenditures. Using a data set of IPOs from 1991 to 1995, Habib and Ljungqvist report that an extra dollar left on the table reduces other marketing expenditures by a dollar. On the first sight, underpricing seems to be just a substitute for marketing expenditures since both have the same cost, but underpricing is much more interesting.

By going public and by underpricing and leaving money on the IPO table, issuing firms can achieve a total coverage media and good news in all media, which can be much more costly if the firm chooses to use publicity and marketing expenditures, mainly because we can not forget the possibility of recouping this money left on the IPO table if the firm has the intention to conduct Seasoned Equity Offerings in the future. So, the issuing firm achieves a large coverage media and an important publicity without spending anything, since the money left on the IPO table will be recouped later. By underpricing, the investors who bought the IPO shares have confidence in the issuing firm, they are satisfied with the gains they retired from the IPO shares and from underpricing in the first day of trading. Optimistic about the value of this firm, these investors will easily accept the price the firm set for its Seasoned Equity Offerings at a later date. Even if the price is higher than necessary, they will accept it since they have confidence in this firm, and then all the money left on the table can be recouped by conducting Seasoned Equity Offerings in the future. 9

II-2-5\ Internet Bubble:

One popular related explanation for the high and severe underpricing of 65% during the Internet bubble (1999-2000) for the U.S IPOs, a peak never reached before in the U.S IPO market, is that underwriters could not justify a higher offer price on Internet IPOs. Even if these firms have a high potential of profitability in the recent future and they are operating in a new but very promising field which will generate high returns later, the underwriters can not justify this and propose a higher offer price. These firms are seen as young and operating in a new field which means that their offerings are risky and they propose risky shares. Proposing a higher offer price will not be accepted by investors and will make them fear the offerings. The issuing firms have to propose a low offer price to incite investors to participate in the offerings even if they are thought to be risky. So, we can say on one hand, the newly issuing Internet firms are very important and are operating in a very promising field and then will generate high returns, but all this can not be justified by their underwriters and they do not find the convincing arguments. On the other hand, and since they are operating in a new field not very known and they are very young firms without a history of returns, they are thought to be risky. So, we are in the same explanation of risk due to valuation uncertainty which was proved to be ineffective determinant and explanation for the underpricing anomaly.

So to explain the severe level of underpricing during the dot-com period, only the inability to justify a higher offer price can be considered as a possible explanation, but the fact of young and so risky firms can not be used as a relevant explanation.

9 As a support for IPO as a marketing event, Chemmanur (1993) proposes that this publicity could generate additional investor interest, and Demers and Lewellen (2003) suggest that the publicity could generate additional product market revenue from greater brand awareness.

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