II-3\ Investor sentiment by Ljungqvist, Nanda and Singh
(2004):
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.
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