Profit Strategy for IPO Underpricing by SG Value Investor, The Value Edge

You often read of the share price of IPO companies jumping on the first day of trading, and it seems like easy money. Now, we examine an IPO strategy is a worthwhile endeavour. By strategy, we refer to an investor subscribing to IPO shares and then selling them on the first day of market close.

Are IPOs typically underpriced?

According to a paper by Loughran, Ritter and Rydqvist, IPOs typically do exhibit large initial returns. While the measurement of initial returns is constructed differently from country to country, they are all confined to the short-term; ranging from a day to several weeks.

Here are the weighted average initial returns of the more established markets:

IPO

For the full list, click here.

This confirms that IPOs are indeed typically underpriced in the short run.

Why are they underpriced?

There are some theories covered in the paper which try to account for this pattern.

  1. To offset winner’s curse. If a stock is good, informed investors will buy it up and the uninformed will not be allotted. However, if a stock is bad, informed investors will not buy and the uninformed will be allotted. Therefore, uninformed investors are always at the losing end and will not want to bid. Underpricing is necessary to attract uninformed investors.
  2. To avoid being sued. Issues and underwriters may be sued for not disclosing sufficient information if the price of the stock should fall on initial trading. Underpricing serves as an efficient form of protection against potential liabilities and damages.
  3. Dispersion of ownership. Underpricing a stock increases demand which causes shares to be rationed and balloted. This will diffused the shareholder base, reducing the number and power of major shareholders.

Can investors profit from this?

It seems like an almost idiot proof strategy that an investor can subscribing to all IPOs equally (in terms of value) will, on average, achieve significant returns (25.8% in the Singapore market). However, we opine that it isn’t so ideal in reality. Stocks that clock gains in the first day of trading are likely to be highly demanded which would make them more difficult to be allotted during IPO. Similarly, stocks which fall in the first day of trading are likely to be relatively unpopular and investors who subscribe to them during IPO will typically be allotted the majority of their subscription. Therefore, the returns of subscribing and selling the IPO shares on the first day should be less ideal than depicted in the paper which is based on weighted average overall returns. To test our hypothesis, we studied the returns of IPOs in 2013 and 2014 YTD.

To account for the issue of over- and under-subscription, we assume an investor subscribes for 50 lots in each IPO. This gives us the probability of allotment and the number of shares allotted for each IPO based on historical balloting results.

IPO

We derive Expected Gains by taking Probability of Allotment x Number of Shares Allotted x (First-day Close – IPO Price). Total Capital is equal to maximum IPO Price x 50000. Based on these, returns would be an unspectacular 2.81%. Note that we have omitted IPOs which have no public tranches or IPOs which we are unable to find balloting results for.

Readers should also be aware of the limitations of our analysis which are due to the assumptions we make. The most significant would be that our calculation of Expected Gain is based on the law of large numbers – as each IPO is unique, extrapolating them based on the law of large numbers may not be conceptually sound.

Conclusion

The profits are slight for an IPO strategy which sells on the first day of trading. Nevertheless, profits are profits and we leave it to each investor to decide if the returns are commensurate with his time.  We leave with a simple reminder that such a strategy is hard to rationalism and investors might succumb to emotional pressures (selling on an intra-day dip in price). In addition, IPOs have been found to overpriced in the long run with a 3-year return of -20% in the US (-9.2% in Singapore from 1980-1990).