The downward trajectory of Facebook’s price after its
Initial Public Offering (IPO) wasn't a great shock. Perhaps the bigger surprise is how many
column inches have been spent analysing a story that can be summarized as “high
price, low earnings, uncertain future”.
Sentiment is a powerful driver of stock prices, but only when there’s
money around to back it up.
In fact IPO’s do seem to be generally subject to
overpricing, which isn’t as obvious a trend as you might expect, given that
owners tend to retain large stakes and to look for ways of retaining control of
their precious creations. For most
retail investors, though, IPO’s are probably best avoided on principle. The principle being not losing money.
Winner's Curses
As we saw in Are IPO’s Bitter Lemons?, the research has
tended to suggest that IPO’s are, if anything, underpriced. There are a bunch of reasons for this, none
of them particularly positive. One of
the more likely causes of a first day trading bounce is the winner’s curse,
where insufficiently knowledgeable punters buy the newly minted stock: in this
analysis the stock isn’t undervalued, but the purchasers are foolish.
The alternative explanation is that insiders are using their
private information to exploit IPO pricing to their own advantage. At face value, if IPO’s are actually
underpriced at issue this doesn’t seem likely but in Are IPO’s Really Underpriced? Amiyatosh Purnanandam and Bhaskaran Swaminathan have argued that this is an illusion:
“While IPOs have been consistently underpriced by 10% or more over the past two decades, we find that in a sample of more than 2,000 IPOs from 1980 to 1997, the median IPO is significantly overvalued at the offer price relative to value metrics based on industry peer price multiples. This overvaluation ranges from 14% to 50% depending on the peer matching criteria.”
The suggestion here is that although money is being left on the table
based on the post-IPO prices achieved, it’s still the case that the initial
price generally overvalues firms. The
likely behavioral explanation is that the initial price spike is driven by
optimists and subsequent performance, usually downward, by earnings. In this
scenario institutional investors can reap the value of any private information
about the real valuation of these stocks by selling into the post-IPO market.
Private Information / Public Foolishness
In The Role of Institutional Investors in Initial Public Offerings the researchers largely confirm the idea that institutions have
private information which they’re able to exploit to maximise their returns:
“We found that institutions sell 70.2% of their IPO allocations in the first year, fully realize the “money left on the table,” and do not dissipate these profits in post-IPO trading … Overall, our results suggest that institutional investors possess significant private information about IPOs, play an important supportive role in the IPO aftermarket, and receive considerable compensation for their participation in IPOs.”
While this may all seem like more evidence that small
private investors face hopelessly overwhelming odds in their attempts to trade
against institutions there’s a strong argument that this issue is already in
the public domain, and that traders who are foolish enough to fall victim to
such problems have only themselves to blame. The research suggesting that we’re all too
eager to jump on the next high-profile bandwagon is all too persuasive:
“We find that individual investors display attention-based buying behavior. They are net buyers on high volume days, net buyers following both extremely negative and extremely positive one-day returns, and net buyers when stocks are in the news. Attention-based buying is similar for large capitalization stocks and for small stocks. The institutional investors in our sample—especially the value strategy investors—do not display attention-based buying”.
(All that Glitters: The Effect of Attention and News on theBuying Behavior of Individual and Institutional Investors, Brad Barber and
Terrance Odean).
Attentional Deficits
The idea is that we tend to select stocks that attract our attention,
and given that there are literally thousands to choose from, we’re more likely
to alight on some well known, highly publicised firm than some dull and dowdy
corporation quietly getting on with its business. High profile IPO’s are, of course, exactly
the kind of thing that attracts unwarranted attention.
This would imply that investors who end up losing as a
result of fooling about with IPO’s shouldn’t be blaming institutional insider
information but should be looking seriously at their own behavioral flaws and,
in particular, how they go about stock selection. This is exactly the point made by Laura
Casares Field and Michelle Lowry in Institutional versus Individual Investment in IPOs: The Importance of Firm Fundamentals.
They start by pointing out that many IPO’s are intrinsically
risky, as they’re young companies with little track record. The variations in three year returns after
IPO range from +1000% for the best performing hundred firms to -99% for the
worst performing hundred. No surprise there, as what can happen, will happen, but associated
with this vast gulf in performance is institutional investment: the best
performers have the highest institutional involvement and the worst have the
lowest.
Behavioral Traps
At face value this appears to be de-facto evidence that
institutions do indeed have privileged knowledge about IPO firms, but the
researchers go further and point out that Barber and Odean’s evidence about
attention-based buying suggests that professional investors are far less likely
to be caught out by this type of simple behavioral trap. They posit that the difference in
institutional involvement between successful and unsuccessful new corporations
is simply caused by professional investors actually bothering to do some proper
research:
“We find no evidence to suggest that institutions’ superior performance results from monitoring activities. Moreover, our results provide little support for the idea that private information contributes substantially to institutions’ ability to identify and avoid the worst-performing firms. Rather, our analysis suggests that the majority of the advantage institutions possess reflects their attention to publicly available information. Institutions are more likely to invest in the types of firms that tend to perform better, and they earn higher returns as a result. Individuals have access to the same information, but they appear to either disregard or misinterpret its relevance for firm value.”
Basically institutions tend to avoid the worst performing
stocks and reap the benefits. They’re
less likely to invest on the basis of a good story and more likely to focus on
whether or not the firm is well run and has decent market opportunities. All of which suggests that heavy institutional
investment in infant corporations is a signal that the firms may be worth
some decent analysis. Stocks with no
institutional support should be avoided.
Unfriending
Overall, as most seasoned private investors know, the IPO
market is fraught with problems. Whether
these are caused by the use of institutional inside information or private
investor mass behavioral mania is pretty much irrelevant; the net effect is
that it’s difficult to figure out the intrinsic value of such corporations in
the wake of an IPO and most private investors should steer well clear until the
situation has stabilized.
Obviously hugely visible flotations such as Facebook will
attract a lot of investor attention. Facebook
is a phenomena, and may well be able to monetize itself to justify the
valuations being placed upon it.
However, in the meantime, more rational investors will wait to see
evidence that it can succeed and will take the performance of the share price
in the wake of its IPO as more evidence that there’s only one action to take
with the unruly connection that is the new issue market: unfriend it.
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