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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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I-2\ Hot IPO market's phenomenon:

As we said before, by their nature the Initial Public Offerings are very sensitive to the state of mind of the investors and to the investor sentiment.

Another characteristic is very important and which ensues of the first characteristic: the Initial Public Offering market is highly cyclical. The cyclical nature of this market has sparked much academic interest. This attention has produced a number of explanations for hot and cold IPO issue markets based on changing business conditions (e.g., Pastor and Veronesi, 2005), investor sentiment (e.g., Ritter, 1991), and asymmetry of information between owners and outside investors (e.g., Myers and Majluff, 1984).

But to explain the notion of «hot IPO market», I focus on the investor sentiment explanation as an important driver and determinant of the IPO market cycles, patterns and phenomena and since it is the object of this thesis.

The phenomenon of «hot IPO market» (Hot market) was for the first time noticed by Ibbotson and Jaffe (1975). These two authors, as well as Ibbotson, Sindelar and Ritter (1988), showed the existence of cycles in the IPO market concerning the monthly number of introductions and the level of initial returns of the shares introduced. Especially, a hot IPO market is a market in which recent IPOs have generated strong and positive initial returns and so high underpricing was observed in the recent past. The sentiment and irrational investors are over optimistic and over enthusiastic about the IPO market, they are exuberant and they show undue interest in newly IPOs, since they have the tendency to project the recent favourable history of the IPO market on the future. In their mind, this positive and favourable tendency will continue for sure and they will make large profits. The market appears to be irrationally optimistic towards IPOs in the short run and so these irrational and over optimistic investors are more willing to purchase the newly IPOs and to pay more to have the newly shares. These irrational investors show excessive demand, they bid up the price of IPO shares beyond true value. The price of shares tends to jump substantially on the first day of trading, the first day closing price is systematically higher than the issue price at which the public offering was introduced in the market, and then IPOs exhibit positive first day returns and so underpricing will be higher. As a result, strong demand towards IPOs and over optimism among irrational investors cause the rise of the stock price during the first trading day. Then, we see the tendency that they have projected when deciding to invest in newly IPOs is maintained. All this is due to the bullish sentiment and the investors' over optimism and their irrational excessive demand, and we talk about a phenomenon much known as a «hot IPO market».

Therefore, more firms will be incited to go public taking advantage of this mistaken belief and of the over optimism of these sentiment and irrational investors. Lee, Shleifer and Thaler (1991), Helwege and Liang (1996), Rajan and Servaes (1997) and Lowry (1999) showed that the volume of IPOs is associated to the positively state of mind of the investors and to their excessive optimism and enthusiasm. The issuing firms are encouraged to go public at this period and to increase the volume of IPO shares they are offering in the stock market.

Loughran, Ritter and Rydqvist (1994) go further in claiming that issuers time their IPOs to coincide with periods of excessive optimism, consistent with the finding in Lee, Schleifer and Thaler (1991) that more companies go public when investor sentiment is high.

Baker and Wurgler (2002) argue that firms may even be able to time their IPO to coincide with periods of excessive valuations which goes in the same direction of the investors' over optimism and over enthusiasm. 10

Helwege and Liang (1996) and Ljungqvist, Nanda and Singh (2002) models find evidence of over optimism in hot IPO markets which confirms the relevance of investor sentiment as a driver of the IPO market cycles, the explanation advanced by Ritter (1991) for the hot IPO market.

Using German data on IPO trading by 5000 retail customers of an online broker, Dorn (2003) documents that retail investors11 overpay for IPOs following periods of high underpricing in recent IPOs, and for IPOs that are in the news.

Consistent with all these findings showing the importance and the major role of investor sentiment and over optimism in IPO market making it cyclical, Michelle Lowry (2003)12 advances that the instability and the movement in Initial Public Offering volume over time both in the number of IPOs and the total proceeds raised in these offerings, can be explained and attributed to the variation in investor optimism level. When investors are overoptimistic, the issuing firms should profit from this period and are incited to offer large volume of IPO and they are sure that the large volume of shares will be absorbed by sentiment investors and vice-versa. The results found by this author indicate that investor sentiment is an important determinant of IPO volume both in statistical and economical terms. The variation in IPO volume is primarily driven by changes in investor optimism, as well as the firms' demands for capital (business cycle), the adverse selection costs (investors' uncertainty about the true value of the issuing firm) which are statistically significant but their economic effect appears small.

The end of the nineties 13 was one of the hottest IPO markets ever. In this period, both the number of initial public offerings and the level of initial returns have reached unprecedented peaks.

Controversially, the IPO market can be in a cold period, the investors' sentiment is bearish and the irrational investors are pessimistic. They observe the recent IPO history which knows

10 Pagano et al. (1998) add that firms «time» their IPOs to coincide with periods of investor optimism, not to exploit investment opportunities, but to realign their balance sheets after large investments and growth.

11 Individual investors

12 Dorn (2003): «Why does IPO volume fluctuate so much?».

13 The dot-com bubble, internet bubble.

negative initial returns, and they project this on the future. They think that the newly IPOs are unattractive and they are dissuaded. They refuse the investment in newly IPOs and they fear the IPO shares which will be overpriced.

This period is known as «cold IPO market». Issuing firms should take into consideration this critical period and it is reasonable to delay their decision to go public until a bull market offers more favourable conditions and pricing to succeed their introduction in the market. However, they surely will fail the introduction if they do not take into consideration the state of the IPO market.

The popular press contains many examples of this viewpoint of the importance of investors' sentiment to decide whether to go public. For example, ``the [current] rule in the IPO market seems to be: Buy it at any price'' (Wall Street Journal, May 20, 1996, p. ) (a period of high sentiment and over optimism), and ``When [investors] get bearish, you can't go public. But when they go bullish, just about anyone can go public'' (Wall Street Journal, April 19, 1999, p. C1.).

Another important remark should be added, if the issuer succeeds the first sales, he is sure that later sales will be succeeded and then he succeeds his introduction in the market taking all the advantages that are related to this success. But if he fails the first sales, taking the decision to go public in a cold market, the introduction in the market will fail conducting even a bankruptcy in the recent future, going with the informational cascades theory of Welch (1992) that I will present in a following paragraph.

Ljungqvist, Nanda and Singh (2003) present another definition for a «cold market», they define it as a market in which there are no exuberant investors and so prices are set by rational investors at fundamental value, so there are nor optimistic neither pessimistic investors who can conduct the IPO pricing. The offerings are priced at their fundamental values.

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