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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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List of tables

Table 1. Average first day returns of some studies ................................................14

Table 2. Descriptive Statistics of the Full Sample ................................................65

Table 3. Descriptive Statistics of Firms with Low Underpricing ..............................67

Table 4. Descriptive Statistics of Firms with High Underpricing ..............................68

Table 5. Average First-day Returns Categorized by Underwriter prestige, Share Overhang, R&D Intensity, VC Backing, Age, Assets, Sales, Firm profitability, Industry, Bargaining Power, Individual Investors' sentiment and Time ................................................69

Table 6. Ordinary Least Squares Regression Results (with Bullish proportion as investors' sentiment measure) ....................................................................................71

Table 7. Ordinary Least Squares Regression Results (with Bullish Bearish Spread as investors' sentiment measure) ..................................................................72

Table 8. Ordinary Least Squares Regression Results .......................................76

Abstract

U

nderpricing phenomenon has intrigued academics and practitioners over the past three decades, and has generated considerable research trying to clarify and to understand this short run puzzle: asymmetric information theories, IPO market efficiency theories and behavioral and sentiment approach. In this study, I regroup in the same model the most important explanations advanced earlier to determine which of these explanations characterizes best the data in the context of a unified framework, with a contribution in the behavioral approach. I use a direct measure of investors' sentiment obtained from the survey data of AAII and II, and I distinguish between the sentiments of the two types of investors: individual and institutional investors.

Sentiment is a primary driver of underpricing and a relevant explanation to this anomaly. Moreover, individual investors are those driving the first day closing prices and are more conducting the short run IPO puzzle than the institutional investors.

INTRODUCTION

G

oing public constitutes a real driver for the development of a company, enabling it to increase its equity capital and to overcome the constraint that its founders are no longer able to provide the capital needed for its expansion, and enabling it to diversify its sources of financing without the need for debt. It is also a way to provide liquidity by creating an opportunity to convert all or some founders and shareholders' wealth into cash immediately or at a future date. Going public is also an opportunity to clarify the company's business and strategy and to think about the company's future growth. Not forgetting the role of going public and being listed in enhancing the company's credibility and strengthening its image and reputation. When a company decides to go public, shares offered in the stock market should be correctly and truly valued. Issuers should also time the Initial Public Offering to coincide with a favourable period (Hot market) to succeed their first introduction in the market. But the question is, if the issuing firm's managers are shrewd enough to value the company's shares and to choose a hot market period, why underpricing is a persistent anomaly characterizing the IPO market and why so much money is leaving on the IPO table?

Stoll and Curley (1970), Logue (1973), Reilly (1973) and Ibbotson (1975), are the first who documented that when companies go public, the first day closing price is systematically higher than the issue price at which the public offering was introduced in the market. They are the first who documented the first day underpricing phenomenon. And Ibbotson (1975) is the first who offered a list of possible explanations for underpricing, many of which were formally explored by other authors in later work.

The underpricing phenomenon has inspired a large theoretical literature over decades trying to give a relevant and a convincing explanation to this first day anomaly. It has intrigued academics and practitioners over the past three decades and has generated considerable research trying to clarify and to understand this phenomenon. The first explanations that were advanced are based on the informational asymmetry between the key parties of an IPO: issuing firm, underwriter and investors. These theories have been very popular among academics and practitioners for decades and have been considered as the most relevant and convincing explanation to the short run IPO anomaly. However, other theories have been introduced asserting the informational transparency and lucidity and the IPO market efficiency, since the first theories based on asymmetric information are unlikely to give a relevant explanation to the surprisingly and severe level of underpricing of 63.5% reached in 1999 and 2000. This severe level of the internet boom years exceeded any level previously seen. Researches are continuing, and it is fair to say that this anomaly is not satisfactorily resolved. It is still a puzzle, since nor the informational asymmetry theories neither the IPO market efficiency theories are likely to give a convincing and a reliable explanation to this short run IPO phenomenon.

Many researchers come to the conclusion that IPO future researches should turn to behavioral approach and sentiment notion. Research effort should focus more on behavioral explanations to clarify and to explain the short run IPO behaviour and the underpricing anomaly: a new path trying to understand and to explain this persistent anomaly. Turning to behavioral explanations seems to be the most promising area of research to understand the short run IPO behaviour.

We can say that the underpricing anomaly may be the most controversial area of IPO research. Research effort has provided numerous analytical advances and empirical insights, but underpricing is not yet explained and the research effort is continuing.

In this thesis, I answer these two main problematics:

Ø What are the most relevant and reliable explanations to the underpricing anomaly from the long list of explanations advanced?

Ø If we rely on behavioral explanations based on investors' sentiment to explain this phenomenon, what type of investors is more conducting the underpricing phenomenon and the first day returns?

To answer these two main questions, I present in a first section the phenomenon and its persistence in time, for all the countries and for all the industries. I present the two main categories of explanations: informational asymmetry and theories asserting the informational transparency and the IPO market efficiency. I summarize the most important findings and results of researchers that have considered these theories in their studies. In a second section, I present the most important studies and papers that have considered the sentiment explanation and the investors' behaviour as the most convincing and relevant driver and determinant of IPO underpricing. In this section, I give an idea about the application of the behavioral and sentiment approach to clarify and to understand the IPO patterns by numerous researchers and I shed light on the importance of the sentiment investors in the IPO market.

Finally, in the third section, I regroup the most important explanations that have been advanced in the same model to determine which of these explanations characterizes best a sample of 217 U.S IPOs for 2006 and 2007. In the context of a unified framework and model, I present the three theories: asymmetric, symmetric and behavioral approach.

For the behavioral approach, I use direct measures of sentiment obtained from the survey data of American Association of Individual Investors and Investors Intelligence. I distinguish between the sentiments of the two types of investors: individual and institutional investors, to answer the second question.

The main result is that sentiment is a primary driver of underpricing and a relevant explanation to this short run anomaly. Moreover, individual investors are those driving the first day closing prices and are more conducting the short run IPO puzzle than the institutional investors.

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