Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing
par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010
We can say that the importance of investor sentiment was introduced and analyzed in the context of the underpricing phenomenon for the first time by Ljungqvist, Nanda and Singh (2004) in their article «Hot markets, Investor sentiment and IPO pricing». The work of these authors is considered the first paper to model an IPO company's optimal response to the presence of sentiment investors. They give a response to the question: what should a profit-maximizing issuer do in the presence of exuberant investor demand and short sale constraints?
They show that underpricing, long-run underperformance and hot-issue markets can be explained by the presence of sentiment investors.
The sentiment investors' behaviour and stocks demand can not be foreseen. All is conducted by feelings and individual beliefs, and the hot market period, characterized by the presence of these sentiment investors who are exuberant and presenting excessive sentiment demand, can end prematurely at any time. And because the hot market can end prematurely, carrying IPO stock in inventory is risky. The optimal mechanism for the issuing firm in the presence of sentiment investors involves underwriters allocating stock to «regulars» to hold it for gradual sale to sentiment investors and to bear the risk of inventory losses in the place of issuers16.
Regulars hold IPO stock in inventory to maintain stock prices by restricting the availability of IPO shares. And they bear the risk of expected inventory losses arising from the possibility that sentiment demand may cease and from the non-zero probability that the hot market will end before all inventory has been unloaded. Then, they are left with IPO stocks and there are no sentiment investors to buy these shares. From the point of view of these authors, underpricing is necessary, it emerges as fair compensation to the regulars for expected inventory losses arising from the possibility that hot market period may end prematurely. As regulars are running the risk of inventory losses in the place of issuers, they require the stock to be underpriced, as compensation for them. They take profit from this underpricing as a reward. But generally, a regular will invest in IPOs only if he does not expect to lose as a consequence. Then underpricing is a necessary cost for the issuing firms emerging from the fact that sentiment investors' behaviour and demand can not be foreseen, and issuers need the regulars to take on this risk in their place and to hold inventory if the demand is small.
So, the optimal selling policy, from the issuer's point of view, usually involves gradual sales. Such staggered sales can be implemented by allocating the IPO to cooperative regular investors who hold inventory for resale in the after-market. These regulars require compensation for bearing the risk of expected inventory losses if the hot market ends prematurely and this compensation is IPO underpricing.
Underpricing is then explained by the presence of irrationally exuberant and sentiment investors whose demand may cease at any time.
16 The risk premium explanation (1st section): underpricing is compensation for underwriters and regular investors for bearing the risk of IPO market crashing and expected inventory losses.
If all the investors are rational and their demand is regular, then it is not necessary to appeal for regular investors to hold stock inventory.
It is surely undeniable that «Hot markets, Investor sentiment and IPO pricing» by Ljungqvist, Nanda and Singh, is considered as the first work that analysed the importance of investor sentiment in the context of underpricing anomaly. The work of these authors is surely the first paper to model an IPO company's optimal response to the presence of sentiment investors. However, these authors did not use a measure for the investor sentiment in their model or a valuation for this explanation of underpricing to check its relevance and its statistical and economical significance. They introduced the investor sentiment as an explanation for underpricing anomaly but did not try to give a valuation to investor sentiment to use it in an econometrical model to concretize their viewpoint and their explanation. They surely presented important ideas and explanations in their article, but did not quantify and concretize their findings and their explanations using real data.
In the following paragraphs, I present a literature review of works and papers that introduce and analyze the investor sentiment as an explanation for the short run IPO anomaly and that try to value the investor sentiment used in a model.