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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-6\ Discount on closed-end funds as proxy for investor sentiment:

The proxies used in empirical works investigating in short run IPO anomaly to value the investor sentiment and to measure its impact on underpricing anomaly are numerous. One of the most important proxies often used by researchers is the discount on closed-end funds. The choice by many authors of the discount on closed-end funds as a proxy of investor sentiment in their works is based on the findings of Lee et al. (1991).

Lee, Shleifer and Thaler (1991) find that both closed-end funds and small stocks are mostly held by individual investors who tend to be noise traders, suggesting that they are more likely than large stocks to be affected by investor sentiment. Lee et al. find that almost a quarter of the variation in monthly returns on the smallest decile of firms is explained by discount changes, even after controlling for general market movements. Their findings suggest that when investor sentiment is higher, individual investors pay relatively more for closed-end funds, and the discount is smaller.

Lee, Shleifer and Thaler (1991), and Lowry (2002) document that «hot issue» periods and «hot IPO market» characterized by high sentiment and over optimism among individual investors coincide with low discount on closed-end funds, their measure of noise traders' optimism and sentiment. They also show that the annual number of IPOs is negatively related to the closed-end fund discount which they argue is a measure of retail investor sentiment: the smaller the closed-end funds discount, the higher the sentiment and optimism among individual investors and the higher the number of IPOs. Over optimistic and enthusiastic investors are more accepting to invest in new issues, and companies are encouraged to take advantage of this opportunity to go public and to offer their shares in the stock market.

Based on these findings, many researchers are convinced that discount on closed-end funds is a relevant proxy that can be used to value the investor sentiment and to study its impact on IPO underpricing anomaly that still a puzzle right now. They use it in their econometrical models.

Ivanov and Lewis (2008) 17 try to identify the determinants of market-wide issue cycles for initial public offerings (IPOs) using an autoregressive conditional count model. They consider whether IPO volume is related to business conditions, investor sentiment, and time variation in adverse selection costs caused by asymmetric information between managers and investors.

17 «The determinants of market-wide issue cycles for initial public offering» (2008)

To value the investor sentiment, they use the quarterly first-difference in the index of closed-end fund discounts as proposed by Lee et al. (1991).

II-7\ Other proxies and empirical results:

The list of proxies used by researchers to value investor sentiment and to study its impact on underpricing anomaly is very long. I presented the most important proxies in the previous paragraphs: grey market prices, market conditions, demand submitted by individual investors and discounts on closed-end funds.

In the present paragraph, I try to give a brief sight on the other proxies that are used by researchers and the main results found:

Rajan and Servaes (2003) model two different types of irrational agents, feedback traders and sentiment investors. They proxy for investor sentiment using the market-to-book ratio and find that it correlates positively with first-day returns and negatively with long-run returns. So there is a positive correlation between investor sentiment valued through market-to-book ratio and underpricing phenomenon.

Other studies have looked at who owns the shares in the aftermarket: for example, Ofek and Richardson (2003) show that high initial returns occur when institutions sell IPO shares to retail investors on the first day.

Similarly, Ben Dor (2003) looks at the level of institutional ownership shortly after the IPO and finds that high institutional ownership forecasts higher returns in «hot» markets.

So, these authors use another proxy to investor sentiment: the holdings of large (institutional) investors. Since these institutional investors have the possibility to sell the IPO shares to sentiment investors in the aftermarket in the first day of trading18.

The proxies for sentiment are numerous like the holdings of large (institutional) investors, put-call ratios, trading volume, market-to-book ratio, market conditions, grey market prices, closed-end fund discounts, and the list is not exhaustive. There is an ongoing inconclusive debate about the effectiveness and explanatory power of many investor sentiment measures (Qui and Welch, 2004).

18 High institutional ownership shortly after the offering is indicating the presence of high and optimistic sentiment among individual investors, and so institutional investors (rich-information investors) can easily sell the shares to these sentiment investors and making large incomes and profits.

Oehler, Rummer and Smith (2005) in their article «IPO Pricing and the Relative Importance of Investor Sentiment-Evidence from Germany» try to explain the persistent pattern of high initial returns during the first trading day. They focus on the importance of investor sentiment and of information gathered by the underwriter before the start of the bookbuilding process. From their viewpoint, there are only two different but not mutually exclusive scenarios which could lead to the observable pattern of high initial returns at the first trading day. First, it could be possible that the offer price is set too low due to ex-ante uncertainty about the true market value of the IPOs. Second, the offer price might be on average at a «fair value» but demand for new issues is overly high and therefore generating the observed high initial returns. They conclude from the estimations realized that underpricing is mainly influenced by investor sentiment and, therefore, by the uncertainty about the demand of potential investors (the 2nd scenario), and less by ex-ante uncertainty about the underlying firm's value. Investor sentiment has the dominant influence on the fluctuations of initial returns and IPO underpricing anomaly.

To value the ex-ante uncertainty about the potential demand and the investor sentiment, they focus first on the bookbuilding price range and the subscription period which are set by the underwriter after observing the potential demand for the stock to be issued, and second on the explanatory power of pre-IPO trading, stock market performance prior to the issue and the usage of the so-called Greenshoe option.

In Europe, the length of the bookbuilding period and the width of the bookbuilding range are set after a pre-marketing period. During this time span IPO research from sell-side and buy-side analysts is produced and distributed by syndicate members to institutional clients (Jenkinson, Morrison and Wilhelm, 2005). As a result, the length of the subscription period and the width of the bookbuilding range are good indicators of how strong the underwriter expects potential demand to be. The longer the subscription period and the wider the initiative price range, the more uncertain is the underwriter about possible success and the higher is the uncertainty about potential demand inducing the importance of investor sentiment which plays a dominant role in influencing the demand. This view is supported by the argument of Jenkinson, Morrison and Wilhelm (2005) who assert that ceteris paribus less available information will lead to an increase in the bookbuilding range.

The authors run regressions with the indicative price range and the subscription period as dependent variables, and find that positive sentiment for IPOs reduces uncertainty about potential demand and then reduces the subscription period and bookbuilding price range.

To value investor sentiment, Oehler, Rummer and Smith (2005) use many proxies: buy-and-hold on the market prior to the IPO which covers a period of 30 days (market movement), Grey market trading prices, business climate over the period of one month prior the IPO, usage of the Greenshoe option which consists in issuing extra shares due to excess demand, and issue volume (number of issued shares including the exercised Greenshoe multiplied by issue price). The authors come to the conclusion that investor sentiment and demand have the dominant influence and impact on initial returns on the first trading day and thus using many proxies for sentiment which they find very significant in their results. It is changes in investor sentiment which have the dominant influence on the fluctuations of initial returns.

They also find another important result that the length of the subscription period and width of the bookbuilding range have negative effects on underpricing.

Aggarwal, Krigman, and Womack (2002) introduce another explanation to first day IPO anomaly. They relate the aftermarket price path to momentum traders. They focus on the role of research analysts and the media in creating momentum and in inducing high investors' sentiment. So to value the investors' sentiment, they focus on the role of media and research analysts: when they are important and favourable to the issuing company and to the IPO, this induces high and positive sentiment among individual investors, and then initial returns are higher and underpricing is more important.

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