Investor sentiment and IPO

LITERATURE REVIEW
Oct 2021
Fatouma Ahmed Ibrahim
Supervisor: Doç.Dr. SITKI SÖNMEZER
 Content
Investor Measure of Investor
sentiment IPO Process sentiment Conclusion

1 3 5 7

2 4 6 8
IPO key Related studies References
IPO Definition
features
INTRODUCTION
Investor sentiment

Cathy (2008) defined investor sentiment in her study in a precise

and concise manner. In the words of the author “Investor
sentiment represents market participants' beliefs about future
cash flows relative to some objective norm, namely the true
fundamental value of the underlying asset.” Beliefs that may be
biaised as a result of wrongly applied genuine information or the
application of false information
Assuming that investor sentiment has an impact on financial
instrument pricing goes against classical finance theory:
• Efficient Market theory
• Rationality of market participants
• Ljungqvist et al. (2001) identified two types of investors:
1. Inexperienced, small investors who aren't active in the stock
market. They depict irrational investors who are prone to
periods of optimism or pessimism.
2. The rational investors, or institutional investors, who have
appropriate, rational ideas about the prospects for the IPO
shares.
IPO Definition

Initial Public Offering (IPO) can be defined as the procedure under which a
private company sells its share for the first time on the stock market.
The company “goes public”
As to why a company goes public, prior literature has explored the following
reasons that could explain the case;
• Value-maximizing incentive by facilitating the sale of the company for a
higher value (Zingales, 1995)
• Allows dispersion of ownership (Chemmanur and Fulghieri, 1999)
• Market timing (Lucas and McDonald, 1990) – Companies issue their shares
when they are overvalued. When investors are overoptimistic.
 IPO Process

04
03 Stabilization

02 Pricing

01 Due Diligence & Filings

Select underwriter
Key features of IPOs

• Initial underpricing
The difference between the offer price and the closing price at the end of the
first day of trading.
Ljungqvist (2007) regrouped the investigated theories behind IPO
underpricing and are as follow:
Asymmetric information models
Institutional explanations
Ownership and Control
Behavioral explanations (investor sentiment)
Hot market
• Defined as “Periods of rising initial returns and increasing number of deals”
(Montier, 2002);
• High IPO volume is triggered by high investor optimism (Lowry, 2003)
• Lowry (2003), with a sample of 5349 IPOs, conducted empirical tests and
industry-level time-series regressions using proxies for 1. demand for capital, 2.
Information asymmetry and 3. Investor sentiment and also an analysis of the
relation between post-IPO stock returns and IPO volume.
• The author concludes that demand for capital and investor sentiment justify
high volumes of IPOs
• She notes that firms that go public during high-volume periods (HOT MARKET)
do not appear to be overvalued relative to other similar firms; it appears that
these firms successfully go public when their entire sector is overvalued.
• Schill (2000) finds similar results.
• Long-run underperformance

• Ritter (1991) presents evidence that abnormally high prices immediately

after the IPO are followed by abnormally low returns in the long-run

• Ritter and Welch (2002) show that This pattern is particularly strong
during ‘hot market’ periods.
They argue that overenthusiasm among retail investors may explain the
much-documented price jumps once trading in newly listed stocks begins, as
well as the subsequent low returns over the first few years of trading.
Measure of Investor
sentiment
Measures of investor sentiment
• Indirect measure of sentiment using proxies
Average Closed-end Fund Discount
NYSE share turnover
Number and average first-day returns on IPO
Equity share in new issues
Dividend premium
• Direct measures of sentiment using surveys (consumer confidence
surveys
• Baker and Wurgler sentiment index (Baker and wurgler, 2006)
The author claim that each sentiment proxy is likely to include a
sentiment component as well as a distinctive, non-sentiment-related
components. He uses principal components analysis to isolate the
common component.
RELATED STUDIES
Derrien (2005)

• Investigated the impact of investor sentiment and IPO

pricing.
• The author developed a model and tested it on a
sample of 62 initial public offerings listed on the French
stock exchange in the period of 1999 to 2001.
• He concluded that the demand of individual investors is
strongly correlated with the market condition and that
they have impact on IPO price.
• IPO shares are overpriced when investor sentiment is
more favorable.
• Also, he observes a positive correlation between their
demand and initial returns and turnover, as well as a
negative correlation with the long run IPO performance.
• Ljungqvist et al (2001)

The authors proceed to develop a model that

links the three main features of IPO
(underpricing, hot market and long-run
underperformance) and discover the source of
the inefficiency.
• He based his study on the hot market of 1999-
2000. He concludes by pointing out the
existence of irrational class of investors have
excessive optimism toward future
performance of IPO being the source of the
issues related to the IPO.
• Cornelli et al. (2004)

• Authors investigated the role of grey market

investors (representing the investor sentiment)
on the price of IPO by using grey market price
data of a large set of European IPOs issues from
1995 to 2002 to explain the issue of
underpricing.
• They conclude that when investors are highly
optimistic the aftermarket prices are high since
they are willing to pay a price above the
fundamental value of the IPO.
• And the long run returns are negatively related
with the grey market prices.
• They also discover that rational investors
perceive investor sentiment and benefit from it
by selling the share to them when they are
optimistic in the aftermarket.
• Purnanandam and Swaminathan
(2003)

The authors compared IPO offer prices to

‘fair values’ computed using various price
multiples of non-IPO industry peers. They
find that issues which are overpriced
relative to fair value also have higher
returns on the first day of trading but
lower returns in the long run.
DN Rathnayake et al. (2019)

In the same spirit, the authors of the paper use a sample of 148 IPOs on
the CSE from 1991 to 2017 and with collected data from company
annual reports and the CSE official website they found that IPOs are
underpriced by 47% and, in addition, that 32 IPOs are overpriced by
between 17%–18%.
The OLS regression model and a cross-sectional analysis were used to
investigate the relationships between initial returns and thirteen
independent variables.
They found that the firm’s issue size, time-lag, investor sentiment, offer
risk, market volatility and hot issue periods have a significant
relationship with IPO returns.
The authors reveal that average overpricing also occurs.
Bajo, Raimondo, (2017)

Their paper added to the literature exploring the link

between finance and the media. They gathered a sample of
2814 IPOs and a total of 27,309 articles published in US
newspapers. They used textual analysis mathematically
formulate the sentiment tone of the newspapers. They
observed that positive tone has a significant impact on the
level of IPO underpricing. In fact, “one standard deviation
in the tone is associated with a roughly 2.5% increase in the
level of underpricing.”
• Gregorie et al, 2020
More recently, the authors added to the literature on the
impact of sentiment on capital markets exploring the effect of
social media twitter, representing a sentiment and attention
generator, on IPO pricing in the primary market.
They used a stochastic frontier model approach and selected a
sample of 412 US IPOs from 2010-2016 period. They
discovered that when the market sentiment is favorable the
offer price is set closer to the maximum achievable price
while the opposite condition has no effect on the
determination of IPOs’ prices.
The number of tweets in the 3 months prior to the IPO,
affects positively the offer price.
Xian (2021)

In accordance with the previously cited authors,

Xian (2021) found similar results concluding
that optimistic sentiment leads to a higher post-
IPO turnover implying the sale of overpriced
IPO share to exuberantly optimistic investors.
Conclusion
Investor sentiment has been studied by a
bunch of scholars examining its impact
on the financial markets and specially on
IPOs.
This study will come under the branch of
behavioral finance which try to track the
sources of anomalies related to market
inefficiencies.
The study will investigate the relation
between IPO(Price, volume and long-run
performance) and investor sentiment.
References
• Baker, M., Wurgler, J., 2006. Investor sentiment and the cross‐section of stock
returns. The Journal of Finance 61, 1645-1680

• Cathy Zhang. Defining, Modeling, and Measuring Investor Sentiment. University of

California, Berkeley. 2008

• Chemmanur, Thomas J. and Paolo Fulghieri, 1999, A theory of the going-public

decision, Review of Financial Studies 12, 249-279.

• Cornelli, F. D. Goldreich and A. Ljungqvist (2004) ‘Investor Sentiment and Pre-Issue

Markets’. NYU Working paper.

• E Bajo, C Raimondo - Journal of Corporate Finance, 2017 – Elsevier

• François Derrien, 2005. "IPO Pricing in 'Hot' Market Conditions: Who Leaves Money
on the Table?," Post-Print hal-00480827, HAL.
References
• GL Gregori, L Marinelli, C Mazzoli and S Severini. (2020) The social side of IPOs:
Twitter sentiment and investors’ attention in the IPO primary market. African Journal of
Business Management. Vol. 14(12), pp. 529-539.

• Ljungqvist, A. (2007). ‘Handbook of empirical corporate finance’. Elsevier

• Ljungqvist, A.,V. Nanda and R. Singh (2001) ‘Hot Markets, Investor Sentiment, and IPO
Pricing’. Stern, NYU Working Paper

• Lowry, Michelle, 2003. "Why does IPO volume fluctuate so much?," Journal of
Financial Economics, Elsevier, vol. 67(1), pages 3-40, January.

• Lucas, Deborah, and Robert McDonald, 1990, Equity issues and stock price dynamics,
Journal of Finance, 45, 1019-1043.

• Montier, J. (2002). Behavioral Finance: insights into irrational minds and markets. Wiley
Finance Series.

• Purnanandam, A., and B. Swaminathan, 2003, “Are IPOs really underpriced?” Review
of Financial Studies, forthcoming.
References
• Rathnayake, Dilesha Nawadali & Louembé, Pierre Axel & Kassi, Diby François & Sun,
Gang & Ning, Ding, 2019. "Are IPOs underpriced or overpriced? Evidence from an
emerging market," Research in International Business and Finance, Elsevier, vol. 50(C),
pages 171 190.

• Ritter, J., 1991, “The long-run performance of initial public offerings,” Journal of Finance
46, 3-27.

• Ritter, J., and I. Welch, 2002, “A review of IPO activity, pricing, and allocation,” Journal of
Finance 57, 1795-1828.

• Schill, M. (1999) ‘Market gaming? An examination of aggregate equity issue clustering’.

University of California Working Paper.

• Ye Xian (2021). Social Media Sentiment and IPO Pricing. 3870563. papers.ssrn.com

• Zingales, Luigi, 1995, Insider ownership and the decision to go public, Review of
Economic Studies 62, 425-448.
 26

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