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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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Section 3- The model and empirical implications


The effect of sentiment investors has been advocated particularly strongly for the Initial Public Offerings' patterns, since by definition, IPO firms have no prior share price history and tend to be young, immature, and relatively informationally opaque. So they are very sensitive to the state of mind of the investors and to investors' feelings and beliefs. A large literature over the past decades, both theoretical and empirical, has attributed the IPO pattern and the short run IPO puzzle to the presence of this type of investors.

The works of researchers who are interested in the behavioral approach and in the investor sentiment explanation to clarify the short run IPO puzzle and to understand the IPO underpricing anomaly are numerous. The list is long and is in continuously growth.

I presented in the previous paragraphs the most important studies and papers that have considered the sentiment explanation and the investor's behaviour as the most convincing and relevant driver and determinant of IPO underpricing. I presented the application of the behavioral and sentiment approach to clarify and to understand the IPO patterns by numerous researchers to shed light on the importance of the sentiment investors in the IPO market.

I continue in the same direction of the behavioral approach and the investor sentiment explanation to the short run IPO puzzle, believing in the relevance of this explanation to clarify and to understand the underpricing phenomenon and in the importance of sentiment investors in the IPO market to explain its anomalies. I presume that there are periods when capital providers (individual and institutional investors) become irrationally enthusiastic about new investment opportunities. In this thesis, we are in the case of the new Initial Public Offerings. They become irrationally overly optimistic about the IPO market. This over optimism is based on the favourable recent history of the IPO market and the positive initial returns recently observed for the new issues. These sentiment investors project this positive tendency on the recent future, believing that the IPO market will continue in the same direction in the recent future for sure. This period is known as «Hot IPO market». The investors' exuberance translates into periods of high demand for Initial Public Offerings, called «sentiment demand» since it is based on sentiment and beliefs. It is far from a perfectly rational demand based on fundamentals, and these sentiment investors are willing to pay higher prices to have IPO shares. As I presented in a previous paragraph, the IPO market is cyclical. There are periods of «hot market», but there are also periods of «cold IPO market» and sentiment investors become overly pessimistic about IPOs.

There are two types of investors: there are individual or retail investors and institutional investors who are more informed and important clients. A question may arise: what type of investors is driving first day closing prices and the underpricing anomaly?

The empirical works and studies investigating in IPO issue activity and particularly in the short run IPO anomaly, using the «traditional explanations» based on the asymmetric or symmetric theories, or using the behavioral approach and the sentiment explanation, draw numerous and different conclusions.

The biggest limitation is that none conduct a comprehensive analysis that evaluates all of the explanations in a systematic manner. None try to present in the same model all the explanations: asymmetric, symmetric and behavioral, to determine which is the most relevant and convincing to explain the short run IPO puzzle, and none try to distinguish between the sentiment of the two types of investors: individual and institutional, to verify which type of investors exactly is driving the underpricing anomaly.

In this study, an effort to regroup the most important explanations that have been advanced in the same model to determine which of these explanations characterizes best the data in the context of a unified framework and model. I introduce the three theories:

Ø Asymmetric information

Ø Symmetric information, and

Ø Behavioral approach.

And since there are two types of investors in the IPO market: individual and institutional investors, one of the goals of this study, is to identify which type is driving the first day closing prices and underpricing by distinguishing between the individual investors' sentiment and the institutional investors' sentiment.

To this end, I use direct measure of sentiment for the two types of investors and this represents another contribution of this work.

The aim in this thesis is to show how sentiment investors and their irrationally overly optimism can lead to a first day price run up and therefore to underpricing, and can explain this short run anomaly with a distinction between the two types of investors in the IPO market to clarify and to understand which type is more conducting the short run IPO puzzle, and using a direct measure of sentiment for each category of investors: the investor sentiment index.

I- The model and explanatory variables:

I-1\ The model:

As I presented in the previous sections, there are numerous explanations advanced to understand and to clarify the short run IPO anomaly. These explanations can be classified in three main categories:

Ø Explanations based on asymmetric information between the key IPO parties and have been considered the most convincing explanations for decades.

Ø Explanations asserting the informational transparency and lucidity and asserting the IPO market efficiency.

Ø And explanations based on Behavioral Approach and on investors' sentiments and beliefs.

I regroup the three theories advanced in the same model to determine which of these explanations characterizes best the data in the context of a unified model and presents the most relevant and reliable explanation to underpricing phenomenon. I present every theory by one or more indicators and determinants.

v For the informational asymmetry theory, I use the firm quality as a determinant with many proxies: the Overhang Ratio, Venture Capital backed, Underwriter reputation and R&D intensity.

v For the theory asserting the IPO market efficiency, I use the risk determinant: age of the issuing firm, firm size (sales and assets), firm profitability, ROA and the issue risk (if the firm operates in a technological and risky sector). I use also the issue size (Ln (expected proceeds)), and the issuer bargaining power.

v Finally, for the behavioral approach, I use direct measures of investor sentiment, and I distinguish between the two types of investors: the individual investor sentiment and the institutional investor sentiment. For this, I use the individual investor sentiment index (AAII) and the institutional investor sentiment index (II).

The regression model used in this study is as follows:

Underpricing = a0 + a1Underwriter Reputation Dummy + a2Overhang + a3R&D Intensity + a4VC Dummy + a5Ln (1+age) + a6Ln (assets) + a7Ln (sales) + a8Firm Profitability + a9ROA + a10Issue Risk Dummy + a11Ln (expected proceeds) + a12Insiders Ownership + a13Institutional Ownership + a14Blockholders Ownership + a15Individual Investor Sentiment + a16Institutional Investor Sentiment+ a17Time Dummy + åi

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