OPINION
2021 Nov/23
The Long-Run Performance of IPOs in the Hot Market and its Implications
Nov. 23, 2021
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- Summary
- Since the Covid-19 outbreak, there have been signs of the hot IPO market, characterized by investor enthusiasm in IPOs and high IPO volumes, and a high trading in the IPO aftermarket. This article analyzed both first-day returns and three-year cumulative abnormal returns (CARs) for IPOs between 2003 and 2018. The analysis on these returns by year showed that in the 2010s the post-IPO three-year returns increased considerably and even surpassed the market return level. This article found that IPOs in the hot IPO market tended to be more underpriced on the first trading day but they showed worse performance in the long run. Therefore, in the hot IPO market, investors need to trade in the IPO aftermarket based on thorough evaluation and analysis, rather than being overly optimistic about prospects of IPOs.
As the Covid-19 pandemic has triggered the stock investment frenzy of retail investors, there has been a growing interest in IPOs. This is particularly demonstrated not only in the pre-IPO subscription rates but also in post-IPO stock turnover ratios. In reality, both have become about 1.5 to 2 times higher since the Covid-19 outbreak. Recently, there is intense media coverage about post-IPO returns as well as subscription rates of IPOs. Under the context, this article tries to explore the initial returns and long-run performance of IPOs between 2003 and 2018, and to identify relevant implications.
Initial and long-run returns of IPOs by year
As illustrated in Figure 1, the average first-day return exceeded 50% during half of the 2000s (from 2000 to 2009).1) But since then, such returns had never been achieved up until 2019, with the first-day returns ranging from 20 to 40%. This is why first-day returns of 53.8% in 2020 and 48.1% in 2021 can be considered abnormal events compared to the 2010s (from 2010 to 2019). Given that first-day returns are usually attributed to high investor interest in and a strong buying of IPO stocks, the IPO market over the last two years appears to be a hot market that has hardly been observed in the past decade.
The Figure 1 shows that three-year CARs on IPOs2) have been positive since 2011. This implies that the long-run returns of IPOs are higher than the returns on the KOSPI over the same period. The result also indicates a sharp increase in IPO returns, compared to negative ones during many years in the 2000s. With the first-day returns taken into consideration, the 2000s saw high first-day returns and low three-year returns, which is quite opposite to the situation in the 2010s. In this respect, this article added to its analysis the three-year performance of IPOs including first-day returns. What’s found is that the three-year CARs of IPOs were higher in the 2010s compared to in the 2000s, even after first-day returns included (see Figure 2). Thus, the participation of IPO firms with high performance appears to have increased over the past decade.
Analysis of CARs on IPOs in hot market and initial returns
Figure 1 shows that if the average first-day IPO return is higher in a certain year, the average long-run performance of IPOs for the same year tends to be worse. Under the context, this article tried to examine what attributes long-run performance of IPOs would exhibit depending on the existence of the hot IPO market or first-day returns. For the examination, a review was conducted with a total of 966 stocks that were publicly offered between 2003 and 2018 excluding REITs, SPACs and the data compiled for the period between 2001 and 2002 (during the IT bubble).
I categorized as a hot IPO market quarters when the average first-day return exceeded 60% (top 20% on a quarterly basis) with more than 13 IPOs (the median on a quarterly basis), while treating the other quarters as a non-hot IPO market. In other words, a hot IPO market can be defined as a quarter that is characterized by an investment craze for publicly offered shares and high IPO volumes. In the hot IPO market, first-day returns on IPOs averaged 81.1% with the three-year CARs reaching 50.7%. This is in stark contrast to the non-hot market where the first-day return and the three-year CAR reached 29.7% and 11.5%, respectively. If the first-day returns are additionally taken into consideration, the three-year CARs on IPOs in the hot market stood at 30.5%, lower than 41.2% measured during the non-hot market. This implies that the offer price in the hot IPO market tended to be more undervalued on the first trading day, but such an offer price proved to be overvalued after three years following IPOs. In a time series analysis, the CARs on stocks listed in the hot IPO market show a steady downward trend during one and a half years from listing and then come back close to the level of the non-hot IPO market.
Figure 4 illustrates the returns on IPOs by the tier of first-day returns. Classifying IPOs into three tiers, top 25%, 25-75%, and 75-100% of first-day returns reveals that only those in the top 25% tier suffer the price decline following IPOs. The average three-year CAR of such IPOs stands at -28.7%, smaller than the CAR in the hot IPO market (-50.7%). Analyzing IPOs in the top 25% tier demonstrated that both the hot IPO and non-hot IPO markets saw similar first-day returns of 109% and 114%, but a wide gap was observed in the three-year CARs of -66.2% and -4.6%, respectively. This trend is also witnessed in IPOs in 25-75% and 75-100% tiers (see Table 1). In other words, most IPOs in the hot market showed a downward trend in prices after being underpriced on the first trading day, while IPOs in the non-hot market hardly saw their prices go down in three years even despite high returns on the first trading day. Consequently, the post-IPO fall in publicly offered share returns appears to be highly associated with the investor sentiment in the hot IPO market.
This article found that IPOs in the hot IPO market tend to have worse long-run performance. This tendency can be explained as follows. Like listed stocks, IPOs are evaluated based on the investors’ expected future cash flow. However, the valuation of IPO stocks could vary by investors’ expectation for growth from new investment based on IPO proceeds, which is quite different from other listed stocks. Notably, such expectation for IPO firms is likely to change drastically depending on future market prospects or varying macro-economic conditions. According to the literature, IPO stocks are greatly sensitive to changes in market returns, with the beta value reaching as high as 2. This implies that the increase (or decrease) of 1% in the market return could cause the IPO return to climb (or fall) by 2%. The hot IPO market can be characterized by the high prices across the market and a positive outlook. This means that expectations for firms listed in that period could have been inflated excessively at the time of the initial offering. Consequently, if any market change dampens investment frenzy, the inflated IPO returns could plummet to such an excessive extent.
Implications
In the 2010s, the long-run performance of IPOs improved significantly compared to previous decades, with their returns surpassing market returns. On the other hand, the IPOs in the hot IPO market tended to show worse long-run performance. Amid the IPO market recently entering into the hot market cycle, retail investors are actively engaging in IPO stock trading. In this regard, this article suggests that, in the hot IPO market, investors need to trade in the IPO aftermarket based on thorough evaluation and analysis, rather than being overly optimistic about prospects of IPOs.
1) Another factor behind high first-day returns in the 2000s could be the underpricing trend that lead managers showed due to putback options.
2) The three-year CAR on an individual IPO was calculated by totaling up monthly abnormal returns (equal to IPO monthly returns minus those ones on the KOSPI) for three years following IPOs.
Initial and long-run returns of IPOs by year
As illustrated in Figure 1, the average first-day return exceeded 50% during half of the 2000s (from 2000 to 2009).1) But since then, such returns had never been achieved up until 2019, with the first-day returns ranging from 20 to 40%. This is why first-day returns of 53.8% in 2020 and 48.1% in 2021 can be considered abnormal events compared to the 2010s (from 2010 to 2019). Given that first-day returns are usually attributed to high investor interest in and a strong buying of IPO stocks, the IPO market over the last two years appears to be a hot market that has hardly been observed in the past decade.
The Figure 1 shows that three-year CARs on IPOs2) have been positive since 2011. This implies that the long-run returns of IPOs are higher than the returns on the KOSPI over the same period. The result also indicates a sharp increase in IPO returns, compared to negative ones during many years in the 2000s. With the first-day returns taken into consideration, the 2000s saw high first-day returns and low three-year returns, which is quite opposite to the situation in the 2010s. In this respect, this article added to its analysis the three-year performance of IPOs including first-day returns. What’s found is that the three-year CARs of IPOs were higher in the 2010s compared to in the 2000s, even after first-day returns included (see Figure 2). Thus, the participation of IPO firms with high performance appears to have increased over the past decade.
Figure 1 shows that if the average first-day IPO return is higher in a certain year, the average long-run performance of IPOs for the same year tends to be worse. Under the context, this article tried to examine what attributes long-run performance of IPOs would exhibit depending on the existence of the hot IPO market or first-day returns. For the examination, a review was conducted with a total of 966 stocks that were publicly offered between 2003 and 2018 excluding REITs, SPACs and the data compiled for the period between 2001 and 2002 (during the IT bubble).
I categorized as a hot IPO market quarters when the average first-day return exceeded 60% (top 20% on a quarterly basis) with more than 13 IPOs (the median on a quarterly basis), while treating the other quarters as a non-hot IPO market. In other words, a hot IPO market can be defined as a quarter that is characterized by an investment craze for publicly offered shares and high IPO volumes. In the hot IPO market, first-day returns on IPOs averaged 81.1% with the three-year CARs reaching 50.7%. This is in stark contrast to the non-hot market where the first-day return and the three-year CAR reached 29.7% and 11.5%, respectively. If the first-day returns are additionally taken into consideration, the three-year CARs on IPOs in the hot market stood at 30.5%, lower than 41.2% measured during the non-hot market. This implies that the offer price in the hot IPO market tended to be more undervalued on the first trading day, but such an offer price proved to be overvalued after three years following IPOs. In a time series analysis, the CARs on stocks listed in the hot IPO market show a steady downward trend during one and a half years from listing and then come back close to the level of the non-hot IPO market.
Implications
In the 2010s, the long-run performance of IPOs improved significantly compared to previous decades, with their returns surpassing market returns. On the other hand, the IPOs in the hot IPO market tended to show worse long-run performance. Amid the IPO market recently entering into the hot market cycle, retail investors are actively engaging in IPO stock trading. In this regard, this article suggests that, in the hot IPO market, investors need to trade in the IPO aftermarket based on thorough evaluation and analysis, rather than being overly optimistic about prospects of IPOs.
1) Another factor behind high first-day returns in the 2000s could be the underpricing trend that lead managers showed due to putback options.
2) The three-year CAR on an individual IPO was calculated by totaling up monthly abnormal returns (equal to IPO monthly returns minus those ones on the KOSPI) for three years following IPOs.