Long run underperformance of initial public offerings: an explanation;

Initial public offerings, even though risky, typically underperform the indices for the first few years after offering. This can be explained by high divergence of opinion raising the initial market price, and by this divergence of opinion declining over time. With time, the valuation of the price setting marginal investor comes closer to the average investor’s valuation. This theory also explains why the firms with the greatest underperformance are those with a short operating history, low sales, low prestige underwriters, low institutional ownership, high volatility, high underpricing at the time of issuance, listing on regional exchanges, and those in certain industries. In the well researched US market, it has been discovered that initial public offerings (IPO’s) underperform the market for the first few years after the offering, when return is measured from the start of trading until three to five years later. Such long run underperformance has also been reported for other markets. This effect should be distinguished from the better known tendency for initial public offerings to be underpriced, and to hence undergo a sharp initial rise from the initial offering price to the start of trading (and hence to the first days close), an effect discussed in the same studies that document the long run underperformance (see references). The argument will proceed in several stages. First the evidence for low returns from US initial public offerings will be summarized. Greater divergence of opinion will then be shown to raise prices. Higher prices alone lower the rate of return for any given stream of dividends. In addition, the divergence of opinion about the typical initial public offering declines over time, and this produces a decline in the stock price. It will then be argued that divergence of opinion declines after an initial public offering and that this can explain the long run underperformance. It will be shown that a number of otherwise puzzling facts related to the cross-sectional variation in the magnitude of the long run price declines can be explained. These include the relationships between return and company size, age, industry, underwriter prestige, institutional ownership, exchange of listing, and initial volatility. Long Run Returns to IPO's Ibbotson (1975), after examining one random selected security from each month in the sixties, found a saucer shaped pattern. There were positive returns near the offering, followed by below market returns, with the fourth year returns tending towards normal. Performance for the first 48 months was below normal. The distribution of returns was highly skewed (most returns negative, but a few very high), indicating that these investments were individually very risky. Given the small sample size and the high standard deviations, the shortfall in performance was not statistically significant. Ritter (1991) examined the returns from 1,526 initial public offerings made between 1975 and 1984. The three-year return was 34.47%. A control sample of 1,526 firms matched for industry and size returned 61.86% over the same three years.