Long-term performance of IPOs: Evidence from Singapore Market
Stock markets are a key part of the capitalistic economic system as they bring together those in need of capital and those with surplus capital to invest. Initial public offerings of companies whose share capital had previously been privately held provides just such an opportunity. The IPO process entails due diligence and pricing by underwriters, after which they underwrite the issue and sell it to investors in the primary market. Following the IPO, the company’s shares trade in the secondary market until the company is shut down or is merged with another company or is acquired. In addition to IPOs, companies which are already public can also participate in capital raising by undertaking secondary stock offerings which investors can use as investment vehicles to increase returns on their portfolios.
Traditional finance theory recommends individual investors to adopt a buy-and-hold strategy for investments in the stock market, since they are unable to time the market, and since the efficient market hypothesis suggests that all available information is immediately incorporated in stock prices. A question this raises is whether long-term buy-and-hold a profitable investment strategy in the initial public offerings (IPOs) asset class for individual investorsAccording to the bulk of literature on this subject, the answer is no. However, there are variations in the results depending upon how the comparison index is selected and what market is being studied. Investors may also be able to select a winning portfolio of buy-and-hold IPO investments if they are successfully able to predict what factors lead to strong or weak price performance in the IPO universe. This study attempts to collect previous research on the subject and apply the learning to the Singapore market. One objective would be to identify ex-post which factors led to IPO success. Indirectly, it may help investors reduce risk and earn strong returns while devising ex-ante investment strategies as well.
First this study will review the existing literature on the subject and summarize its conclusions. Then it will use the statistical methods used by prominent studies such as Loughran and Ritter (1995) to calculate whether IPOs have underperformed the market in Singapore. The study will also collect what other papers have identified as sources of high performance within the universe of IPOs and see whether these results hold in IPOs in Singapore as well. Some of these factors include high percentage of institutional ownership, venture backing, industry and age of the company at IPO.
Equity investors are constantly looking to maximize their risk-adjusted returns by investing in various asset classes in financial markets. The results from the literature lead to the conclusion that a strategy of buy-and-hold investments in IPOs underperforms the market on average. What would be interesting and useful would be to see whether a subset of IPOs can be identified where this result does not hold and where a different version of the strategy can be shown to produce a higher return for investors than the index or benchmark portfolio.
The objective of the research is to study performance of Singapore listed IPOs using factors which have been identified in academic literature as having effect on IPO performance, including:
percentage of institutional ownership
reputation of the underwriter
age of the company at IPO
legal and institutional environment
The ultimate objective is to see whether factors can be identified that lead to recommendation of alternative investment strategies which perform better than buy-and-hold of IPOs for a multiple year holding period.
IPOs listed on the Singapore stock exchange during the five year period of 2000 – 2004 would initially be identified. Subsequently, 3-year, 5-year and 10-year buy-and-hold returns of these portfolios would be calculated and compared to returns over the same period by a stock exchange index such as the Strait Times Index (STI). Another method for comparing results to market could be the selection and composition of a matching portfolio which would be used to compare underperformance or overperformance over the holding period. To create a matching portfolio, a similar sized public company that did not issue equity for five years prior to the IPO date would have to be selected for each IPO company. The return on the matching portfolio would be compared to the return on the IPO portfolio as per Loughran and Ritter (1995). It will be assumed that investors would purchase shares in the secondary market and none of them would be lucky enough to be allocated shares by the underwriter at the offering price.
Underperformance of IPOs relative to market indices has been studied extensively in academic literature. One series of articles examines the degree of underperformance of IPOs relative to market indices and asks what factors could cause such underperformance. Factors typically examined include size of the IPO, the company’s industry, whether the company is venture backed or not, the degree of institutional holdings, age of the company at IPO, quality of the underwriter and the institutional and legal environment of the company.
Another string of literature looks at empirical evidence of underperformance in different markets, including the US, several European countries including Germany (Stehle, Ehrhardt & Przyborowsky, 2000), Switzerland and Greece and several developing Asian markets such as Malaysia, Taiwan and China. Most of these studies take time series data of IPOs during a given period of time. Then they look at nominal buy-and-hold returns over 3 or 5 years, typically without assuming any portfolio rebalancing, though as shown by Brav and Gompers (1997), the results hold even if portfolio rebalancing is introduced. The returns of individual IPOs are compared with results of an industry index such as S&P 500, Nasdaq or NYSE, or with an industry benchmark portfolio (value weighted or equally weighted).
The typical pattern of IPO returns that emerges is the following: After a period of strong performance following an IPO, the stock starts to underperform the market index. This period of poor performance lasts for several years. The length of the period of initial strong performance lasts up to several months, depending on whether or not the stock market is in a bullish state.
Ritter (1991) examines both underpricing of IPOs and their underperformance. Underpricing is a phenomenon in which investment banks taking a company public, and wanting to manage their own risk, keep offer price low in order to build a strong deal book and to keep market participants incentivized for participation in the offering. This is reflected in the fact that on average there is a 16.4% gain from the offering price to the closing price on the first day.
In addition, the author believes the IPOs appear to be overpriced when 3-year IPO returns are compared to 3-year returns for comparable firms matched by size and industry. In a sample of 1526 common stock IPOs between 1975 and 1984, IPOs produced a return of 34.47% and seasoned offerings produced a return of 61.86%, 3-years after going public. Upon careful examination of the sample, the author concludes that the cause of the underperformance are those small IPOs that benefit in the short-run due to optimistic market conditions, but which are not able to establish themselves in the long-run.
Loughran and Ritter (1995) find that all issues, both IPO and secondary, offered during 1970 to 1990 produced poor long-term returns for investors. Using a strategy of 5-year buy and hold investing would have produced a result of only 5% per annum for IPOs and 7% per annum for secondary offerings. The authors highlight an important observation for potential underperformance by secondary offerings (SEOs) – most public companies opt for secondary offerings following high return periods in the market; thus their subsequent underperformance may simply be linked to eventual reversion of returns to their long-term averages. In order to judge the performance of secondary offerings, for each issuing firm the study choose a non-issuing matching firm that is similar in size and has not issued equity in the previous 5 years.
The authors calculate wealth relatives for each year as the ratio of end-of-period wealth from holding a portfolio of matching firms with the same starting market capitalization. The ratio is below 1 in most years indicating that investors would have been better off investing in buy-and-hold strategy in non-issuing firms. The authors conclude that it is not advisable for investors to invest in shares of companies issuing stock. Instead investors would be able to generate the same return with 44% less capital if they simply invested in similar size non-issuing companies for the same holding period.
The results in Loughran and Ritter (1995) do not control for industry since it is often difficult to find matching companies in the industry which also share similar size. According to a study by Spiess and Afflect-Greaves (1995) nearly one-third of the long-run underperformance of secondary offerings comes from industry effect. Another potential explanation for why this happens is offered by Lerner (1994) – firms which are not yet ready to grow cashflows consistently sometimes take advantage of the IPO window during bull markets and other periods of market exuberance, only to then suffer from poor market performance when cashflows do not keep pace with market expectations (Clark, 2002; Ljungqvist, Nanda & Singh, 2006).
If long-term IPO returns are infact so dismal, why do investors keep buying IPOs during all market cyclesAn insight into the solution is provided by Field (1995). The author analyzes the impact of the extent of institutional shareholding on long-term IPO performance and concludes that IPO having large holdings by institutions earn significantly higher long-term returns than those with low institutional holdings. Institutional holdings also differ substantially between industries. In fact, the latter category often fails to achieve even the risk-free rate of return available to bondholders. The author concludes that there are groups of IPOs which do not experience poor long-term performance, though they may be identifiable ex-ante.
Other authors also identify factors that can lead groups of IPOs to have relatively strong performance. For example, Michaely and Shaw (1994) identify reputation of underwriter as one of the factors that is directly related to IPO return. Brav and Gompers (1997) find that venture backed IPOs outperformed non-venture backed IPOs significantly. The 5-year buy-and-hold return for venture backed IPOs was 44.6% while the equivalent figure for non-venture backed IPOs was 22.5%. These results were calculated based on equally weighting of components in an index, whereas if the index is value weighted then these differences are significantly reduced. The authors believe that their results might have inspired by the fact that venture backed companies tend to be those which are in growth industries and are at an early stage of their development cycle. Such companies are likely to have many good investment opportunities. The authors also find that underperformance resides primarily in small, non-venture backed IPOs. Qualitatively similar results are also provided by Bessler and Seim (2011) who study European venture backed IPOs.
Turning to the second string of literature which deals with tests of IPO underperformance in different geographies, it appears that this phenomenon holds in both developed and less developed markets. While, the original hypothesis was formulated for the U.S. market, it holds to various degrees in most markets. Thomadakis, Nounis and Gounopoulous (2012) study performance of 254 IPOs during the 1994 – 2002 period. They find that the period of initial overperformance in Greece lasts longer than it does in western markets. While IPOs outperform the market in the first two years, by the third year underperformance sets in. The authors attribute this to longer ‘hot’ periods in the Greek market than in more developed western markets.
In a study on the same subject in Taiwan, Wen and Cao (2013) find that IPOs perform as well as matching reference portfolios in the first year of trading and then start to underperform that portfolio. Drobetz, Kammerman and Walchli (2005) examine the same in the Swiss market. They find that while underperformance holds, it is much weaker than is suggested by equivalent tests from the US market. Chan, Wei and Wang (2001) find practically no underperformance of class A and B shares, though there is significantly higher underpricing of Class A shares compared to other markets. In another study on the Chinese stock market, Chi and Padgett (2002) find strong performance of Chinese Privatization IPOs, which the authors attribute to government ownership, offering size and belonging to the high tech industry.
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