IPO analysis Guru: Ivo Welch

Finance professor Ivo Welch has an excellent ''resource page" of IPO data, literature and links on his website. One feature is an assessment of the twin phenomena of short-run underpricing and long-run underperformance of new issues. On the first point, Welch notes that the typical IPO underpricing the return from the offer price to the price when the market starts trading is about 10%, an astonishing figure for an average daily return. He asks why issuers "leave so much money on the table" and suggests a number of reasons:

When applying for shares in an IPO, you will typically get all the shares you requested if it is overpriced you are a victim of the winner's curse. But when an IPO is underpriced, you will only get shares on rare occasions, especially if you are not a favored client of the underwriters. As a result, you come out down on average and are unlikely to apply for shares in a fair-priced offering. So to get you to participate at all, issuers set a lower price, and while it appears that the average IPO leaves money on the table, the typical investor cannot profit from it.

Issuers like to donate some money to investors since they may want to return later for further funds. Investors will remember how good a deal they got with the IPO.

Underpricing solicits information from investors about their potential interest. Why would investors tell underwriters they like an offering unless they know that by doing so, the underwriter will give them more shares for a better price?

If one important investor defects, maybe all investors will follow. Hence, to ensure the first investor does not defect, it is better to play it safe and underprice.

There is an agency problem for the issuer: because underwriters naturally prefer easier to harder work (especially when the price is high, which makes selling difficult), it is best to make selling a little easier for them and underprice.

While IPOs can be very profitable for institutions with relatively short investment horizons and which have access to them at their offer price, this is rather like a quick payback for early support. For in the longer term, new issues are not attractive investments. A significant body of evidence indicates that on aggregate, they have underperformed the market, typically 3050% below comparable companies over three- to five-year periods. A study by Tim Loughran and Jay Ritter discusses some of that research and presents their own findings, which confirm IPOs' poor performance.

How can this long-run underperformance be explained? Welch explores the two most prominent explanations, the first of which is that corporate managers are smarter than the market and thus good at timing, taking advantage of overpriced stock. The second is that managers manipulate earnings, past and forecast, dressing IPOs up for sale. While analysts advising investors should spot these exaggerated figures, they are paid by firms in the business of selling IPOs.

Understanding IPO

One of the most seemingly attractive areas of investment is that of initial public offerings (IPOs). Buying shares the first time they are offered to the public has considerable natural appeal, especially in a bull market, tempting investors with potentially phenomenal short-term returns as well as exposure to exciting new companies and industries. And since the early 1980s, privatizations of state-owned enterprises around the world have become an additional source of new issues, providing investors with the opportunity to get low-priced stakes in big, stable businesses, often the dominant incumbents in core sectors of the global economy.

The objective of any new issue is to achieve the highest value for the issuer, while ensuring a buoyant start to secondary trading. Shares are generally offered at a fixed price, set by the sponsors of the issue, and based on multiples, forecasts of likely future profits, or a combination of multiples and forecasts. Alternatively, in countries outside the United States, like the UK, there might be a tender offer, where no price is set in advance, leaving it to the market forces of demand and supply.

Fixed-price IPOs are frequently underpriced, providing opportunities for stags, investors who buy in anticipation of an immediate price rise. Big instant profits may often be made if shares can be purchased at the offer price and sold soon after dealing begins returns in the order of 515% in one day, but with high variance across offerings. Understandably, such offers are often oversubscribed, leaving the sponsors to decide on the appropriate equity allocation: by ballot, by scaling-down large applications, or by giving preferential treatment to certain investors, typically their favored clients though in some cases the private investor. The method varies by country: in some countries, like the United States, it is discretionary; in others, it is mandated equal for equal submissions.
The UK privatization issues of the 1980s and 1990s tended to be markedly underpriced, sometimes coming with incentives for the private investor, and positively discriminating against the institutions in terms of allocation and even price. They have generally been regarded as a success in terms of investor returns, government revenues and improvement in corporate performance. Certainly, the UK program has inspired numerous other governments around the world to begin turning their public-sector companies into publicly quoted ones, though perhaps this is more inspired by the real performance of companies post-IPO than the amount raised at the IPO.

Like privatizations, private sector new issues are often viewed as a route to quick and easy profits, but for every ten or so successes, there is usually one that goes wrong or seriously fails to perform. Indeed, one study of the US market reveals that of nearly 5000 IPOs initiated between May 1988 and July 1998, nearly a third no longer trade their stock and 44% sell at a market price below their original offering price.

So private investors must always show great caution, being careful to study the prospectus, balance sheet and profit and loss account of any potential investment. Investing in IPOs is intrinsically risky and not for the faint of heart. Companies that have recently reported very good results or which are in fashionable industries with their best results at an indeterminate point in the future should be scrutinized especially diligently.

Investors should also note that conflicts of interest and potential abuses are rife in the distribution of new issues. IPOs are inevitably timed to benefit the seller not the buyer, aiming to extract the maximum value from the market. Indeed, several studies indicate that IPOs are usually not good investments, underperforming the market over the longer term. This may be a reflection of companies preparing the numbers for a couple of years, and underwriters overhyping and sales people overselling the shares. Such activities may be particularly prevalent in the late stages of a bull market.

The Future of Indexing

Today, indexing might be 20% of total US institutional equity. And now indexing is done on a number of indices like emerging markets, industry groups and other security classes. It is rather surprising that it is not greater. One feature that may have been restraining growth is the agency cover of indexing, which is not as great as with an active manager: more of the responsibility of investment selection may, under some interpretations, reside with the index client than with active managers. Furthermore, if equity markets have an extended decline, indexing may be arrested in its growth.

Indexing lends itself well to being packaged with other services like performance measurement, custody and administration and corporate governance monitoring (see Performance Measurement and Corporate Governance). Thus, the management cost of indexing is often bundled with services customarily offered by large integrated banks.

Indexing is a strategy that has been applied to many different categories of investing. It provides an efficient way for investors to participate in broadly diversified portfolios. Nevertheless, many investors will continue to be attracted to the distinctive investment philosophies and strategies offered by the wide range of actively managed funds (see Active Portfolio Management). A suitable compromise may be to build equity and bond portfolios (or even combine them through a balanced approach) with a core holding in an appropriate index fund. Around that core investment, an investor may select specific actively managed funds that appear likely, in the investor's judgment, to add incremental investment performance over the long run.

Critics on Indexing

Indexing derives originally from the concept of market efficiency (see Market Efficiency). But markets are efficient only if investors study all available information and move prices to reflect the published data. This implies that as the market share of indexers rises, institutions will employ fewer and fewer analysts, the market will become less efficient, and this will give active managers the chance to outperform the index and index managers.

Of course, there will always be actively managed funds that outpace index funds over long periods. But is it luck or skill? Probability indicates that some investment managers may provide exceptional returns over lengthy winning streaks. But there may also be some investment managers with truly outstanding abilities who can earn superior returns over time. The problem in selecting actively managed funds is how to identify in advance those that will be consistently superior over time.

On the surface, all stock index funds should have identical total returns. But they do not because their expenses vary. Expense ratios (the percentage of costs to assets) generally range from 0.2-0.6%. The average for actively managed funds is 1.3%. Since many index funds began only in the past few years, the high-cost ones usually justify themselves by saying there was a significant start-up
expense. And some index managers admit privately that high expenses exist because the funds feel they can get away with it.

Another potential problem with indexing relates to corporate governance. As indexing took off, proxy voting slowly became an issue when the normal tool for expressing dissatisfaction with corporate behavior liquidation of a stock position was unavailable.

Part of the index fund advantage has resulted from being 100% invested in stocks at all times in a bull market buying stocks going up and selling those going down because of companies going in and out of the index. Indeed, this drives up the market as trackers are fully invested and do not allocate assets between equities, bonds and cash. Since most equity funds maintain cash reserves of 5-10% of net assets, they lost ground to index funds in the bull market in stocks during the 1980s and 1990s.

Of course, in periods of market declines, index funds can be expected to have somewhat larger declines than funds maintaining cash reserves. Yet they may convey the illusion of safety. Stock picking may work better in a flat or bear market another justification for active managers.

Wells Fargo and Indexing

Early proponents of indexing were Wells Fargo, American National Bank and Batterymarch. Each had a slight variation that was designed to be superior; each had a booster or two from academia and each garnered a small percentage of some of the large pension funds in the United States. Curiously, university endowment funds, run by successful alumni, not faculty, were not among the early entrants.

Timing of the acceptance of indexing was critical. Following the nearly 50% US market decline in 19734, new ideas which might have been rejected just a few years earlier were sought. Ideas that challenged convention were readily accepted since conventional ideas had just demonstrated they could be costly in a decline. Each market phase brings forth its selection of new strategies to support hope and expectations. Indexing was right for the time and the time was right for indexing.

Wells Fargo endorsed investment in the full S&P 500 stock index with only a handful of de-selectees for prudence (reputedly, these handily outperformed even a risk-adjusted measure). American National had a sophisticated sampling technique to reduce transaction costs, a likely source of underperformance. And Batterymarch, thinking that index investors would ignore month to month wiggles of sampling error that would cancel in time, just bought the largest 250 stocks, which were 90% of the total. Batterymarch also tried, and failed, to promote the notion that low cost mechanical replication of any index, not just the S&P, was the goal.

Early clients were happy with the results, which kept pace with active managers even when small stocks pulled ahead in the new, quantitatively-driven market then just beginning. And more money came into the strategy in the billions. Meanwhile, the debates between passive managers, as the indexers were called in error

What is Indexing?

Indexing is an investment practice that aims to match the returns of a specified market benchmark. An indexing manager or tracker attempts to replicate the target index by holding all or, with very large indexes, a representative sample of the securities in the index. Traditional active management is avoided with no investments made in individual stocks or industry sectors in an effort to beat the index. The indexing approach is often described as passive, emphasizing broad diversification, low trading activity and low costs.

Indexing as an investment practice has won acceptability in the last two decades as the mechanical outgrowth of a body of academic insights about markets and managers. Indeed, it was one of the first ideas to be propounded by finance academics from their empirical studies. These pointed out that the average manager would produce sub-average results due to expenses and above average managers would be identified and given more assets until they too became less than average. The system was the trap. After all, index accounts have prices set by all managers. In a sense, these accounts are the most managed of portfolios.

Indexing seems dull. Stock selection is done by a nameless committee at Standard & Poor's (S&P) or elsewhere for other indexes. Proportions are set by market prices, which are the aggregate wisdom of all participants. And administration is relatively simple because transactions are bunched together at the very instant at month end when the index composition may be rearranged.

In the late stages of the one-decision bull market of the 1960s, the idea of mechanically investing in the average just because it was the average would have failed. But in the mid-1970s, when a sharp market correction slayed the old gods and raised up new ones, it was just the thing. Nothing could challenge a roster of active, aggressive managers better than to have a mechanical bunny running the performance race with them and the bunny did not require dog food.

The Future of Hedge Funds

Hedge funds and their appetite for risk continue to appeal to investors, perhaps reflecting the late stages of a bull market, where attitudes to risk shift in two complementary ways: the future appears less risky; and, at the same time, investors' appetite for risk rises. But their bad experiences in 1998, the possibility of worse in the future, and the potential regulatory backlash suggest that their fashionable status as high-end mutual funds may wane.

But one hedge fund manager definitely worth continuing to be aware of is James Cramer of Cramer, Berkowitz & Co., who is also co-founder, co-chairman and contributing editor of TheStreet.com, an online financial publication self-described as "dedicated to providing investors with timely, insightful, and irreverent reporting and bringing accountability to the markets and the media that cover them." This is one of the most entertaining investment sites on the internet.