This article mainly studies the phenomenon of China's A-share IPOs underpricing, using 267 samples of new issues listed on Shanghai stock exchange and Shenzhen stock exchange from 1st January 2006 to 31st December 2008. First, this paper shows several theories to explain IPOs underpricing, such as the information asymmetry, institutional explanation, ownership and control and underwriter's reputation. Second, the empirical results show that the average initial return from 2006 to 2008 was approximately 130%. This paper also shows that 1) there is a positive relation between the percent of state-owned shares and initial return of IPOs. 2) There is a negative relation between the price of new shares and initial return of IPOs. 3) P/E ratio is positively related to initial return of IPOs. 4) The number of IPOs being issued is inversely related to initial return of IPOs. 5) The rate of winning lottery and initial return of IPOs are negatively proportional.
Chapter One: Introduction
1.1 Context
Initial Public Offerings (IPOs), which can be defined as a company who first time sells this company's stocks to the public has already become the hot topic of discussion in the financial research as well as the media news. An IPO may be offered by a new company or an old company which has been operated for many years. A successful IPO will have the great significance to the development of a company in the future. It does not only make a company rapidly raising the massive capitals and expand operating scale of the company, but also will be helpful to improve capital structure of the corporate, realize sustainable development and finally achieve the goal of value maximization.
The pricing of IPOs is the main factor to determine the new shares whether can be issued successfully or not. The reasonable pricing can ensure the success of new shares issued. However, actually, an enterprise's IPO is generally issued at a price below the real price of stock. It will enable companies to produce the initial return whose definition is that 'the first day closing price minus the offering pricing divided by the offering price' (Chang et al., 2008). The offering price is always lower than the closing price on the first trading day and the excessive initial return is generally produced in a short time. It has been shown that IPOs underpricing phenomenon exists in the stock market all over the world. The developing countries on IPOs underpricing may be higher than that of developed countries. In the developed countries, the highest degree of IPOs underpricing was Switzerland which was only 34.9% during 1983 and 2000, while the developing counties such as China, the figure reached 256.9% from 1990 to 2000 (Loughran et al., 1994). Therefore, abnormal return of IPOs attracts people's widespread attention and causes more studies by scholars.
1.2 Research rationale
The reason why this paper selects Chinese IPOs market as the study object is that first China's stock market has developed rapidly in recent years. The initial return of the Chinese IPOs is the highest in the world. Furthermore, China's stock market has some special institutional features. For example, there are special issuing methods and the Chinese government can determine the pricing of IPOs. Also, during the period of 2006 and 2008, there are fewer papers to research the Chinese IPOs market.
1.3 Aim and objective
This paper will attempt to study the anomaly of IPOs which have first-day underpricing puzzle in the Chinese A-share stock market from 1st January 2006 to 31st December 2008. The aim of this paper is going to attempt to investigate how A-share IPOs underpricing can be affected by some factors in China. In order to demonstrate this, first, it will be shown that initial abnormal return is significantly positive in China, that is, the extent of IPOs underpricing is quite large on the first trading day. Secondly, this paper mainly tests information asymmetry theory to explain China's IPOs underpricing though regression analysis. It can be seen that five determinants (LotterRate, Percent, IssueP, Lnum, P/E) may explain China's A-share IPOs underpricing from 2006 to 2008.
1.4 Paper outline
The other chapters of this paper are organized as follow. Chapter two offers a literature review about IPOs underpricing theory. Chapter three presents the features of the Chinese stock market and IPOs. Chapter four provides some hypotheses and indicates the data and methodology. Chapter five carries on the empirical tests and analyses the empirical results. Chapter six presents a conclusion.
Chapter Two: Literature review
As for IPOs underpricing puzzle, many scholars have proposed many kinds of theories to explain this phenomenon during these years. Reilly and Hatfield (1969) first analyzed 53 new issues return on the US's listed companies from 1963 to 1965. These two researchers show that average initial return of new issues is higher than market benchmark. After that, a lot of scholars conduct the massive research regarding IPOs underpricing (Ibbotson, 1975,1982) and confirm that there was an initial return about 16% on common stock market in the USA from 1977 to 1982 (Ritter, 1987). In recent years, this phenomenon can be mainly explained by following several theories. In this section, it can be illustrated the reasons of IPOs underpricing from four aspects, asymmetric information, institutional explanations, ownership and control and underwriter's reputation hypothesis.
2.1 Information asymmetry and IPOs underpricing
A basic reason of underpricing is that information asymmetry exists among the issuers, underwriters and investors (Loughran and Ritter, 2004). Baron (1982) was the first person to propose information asymmetry's model. Base on Baron's theory, Rock (1986) offers a famous theory of IPOs underpricing: winner's curse.
2.1.1 Winner's curse
Rock (1986) argues that there are two types of investors in the stock market that can be called 'informed' and 'uninformed' investors. The informed investors know more information regarding the real value of shares, whereas uninformed investors know less IPOs information. These two kinds of investors do not have any communication. Informed investors just purchase valued IPOs, while uninformed investors do not know which new issues are valued. Therefore, uninformed investors tend to subscribe overpriced new issues and then face a 'winner's curse'.
This phenomenon may cause uninformed investors to reduce the new stocks subscriptions. In order to attract uninformed investors to subscribe the new issues, the issuers have to offer a discount on the IPOs. However it is assumed that the lower is the price of IPOs, the larger is the demand for the new issues. It causes that investors have a lower rate of winning the lottery. On the other hand, as for informed investors, IPOs underpricing is a key to ensure issue success. That is because an informed investor can not bid a premium stock. Therefore, according to Beatty and Ritter (1986), the new shares need to reduce the offering price with the reasonable extent. Levis (1990) chose 123 samples from UK's stock market between 1985 and 1988. It has been proved that winner's curse problem can explain initial return of IPOs in UK. Rock's model is also confirmed by different stock markets such as in Singapore and Finland (Koh and Walter, 1989; Keloharju, 1993). However, McGuinness (1993) examines Hong Kong's IPOs from 1980 to 1990 and this empirical evidence does not support Rock's winner's curse.
Table 2.1 Selected studies of Winner's curse hypothesis
Papers
Sample period
Findings
Levis (1990)
1985-1988
It has been proved that winner's curse problem can explain initial return of IPOs in UK.
McGuinness(1993)
1980-1990
It examines Hong Kong IPOs from 1980 to 1990 and this empirical evidence does not support Rock's winner's curse.
Rock(1986)
Rock offers winner's curse and argues that there are two types of investors in the stock market that can be called 'informed' and 'uninformed' investors. The informed investors know more information regarding the real value of shares, whereas uninformed investors know less IPOs information.
Loughan and Ritter (2004)
A basic reason of underpricing is that information asymmetry exists among the issuers, underwriters and investors.
Baron (1982)
Baron was the first person to propose information asymmetry's model.
2.1.2 Ex ante uncertainty
Based on Rock's theory in 1984, Beatty and Ritter (1986) propose this concept of ex ante uncertainty to explain IPOs underpricing. Draho (2001) also thinks that there is a positive relationship between the ex ante uncertainty and IPOs underpricing, namely, the bigger uncertainty, the higher level of underpricing. When the level of uncertainty is higher, there may be an increase on the number of investors collecting IPOs information. Consequently, investors should underprice IPOs in order to compensate the cost of collecting information for investors. On the other hand, uninformed investors may encounter a winner's course. However, if most investors have better information, the winner's curse possibly dose not exists (Beatty and Ritter, 1986).
Jenkinson and Ljungqvist (2007) illustrate that there are many proxies to be measured the ex ante uncertainty. Beatty (1989), Liu and Li (2000) and Chi and Padgett (2005) study by empirical analysis, the same result is that offering size is negatively related to initial return of IPOs. Also, there is a positive relationship between IPOs underpricing and the time lags between offering and listing date (Chan et al., 2004). As for age of a firm, it is inversely related to IPOs underpricing (Ritter, 1984; Megginson and Weiss, 1991; Yu and Tse, 2006).
2.1.3 Signaling hypothesis
Another famous hypothesis is signaling theory which reverses winner's course assumption proposed by Rock in 1986. If the issuing company knows more information about IPOs than outside investors, this issuing company may possibly underprice new shares to render investors convincing its high quality, such as strong profitability and a good prospect for development. Allen and Faulhaber (1989) and Grinblatt and Hwang (1989) have concluded that underpricing of IPOs can be regarded as a signal of powerful company. That is, a high-quality firm who offers a discount offering price is because this firm has the great strength to make up for the losses of new shares undervalued. By contrast, the company whose strength is relatively weak may not adopt an IPO underpricing. If the performance of this firm is not good enough after the company going public, then the SEO (seasoned equity offering) can not compensate the losses of IPOs underpricing before. Also, the secondary market's stock price is lower than the price of new shares. If investors in the absence of inside information of issuing companies, it possibly tends to bid the shares in the secondary market. Therefore, the issuer making IPOs discount is also a mean to attract the investors to purchase the new stocks (Chen et al., 2004). Yu and Tse (2006) have studied the Chinese IPOs data from 1995 to 1998. They conclude that winner's curse assumption may be the main reason for such a high IPOs underpricing, while signaling hypothesis is not sustained in China. However, Su and Fleisher (1999) examine that signaling theory is a strategic mean to signal outside investors the value of company.
Generally speaking, the company going public aims to the following larger issue. The IPOs underpricing on the first trading day enables listed companies to leave a good impression to the investors. Ibbotson (1975), Welch (1989) and Jegadeesh et al. (1993) argue that the higher the initial return of IPOs, the bigger the probability of SEO in the future. However, Michaely and Shaw (1994) are not in favor of signaling hypothesis. They believe that issuing companies which tend to SEO can not explain the phenomenon of IPOs underpricing.
Table 2.2 Selected studies of Ex ante uncertainty hypothesis and signaling hypothesis
Papers
Findings
Beatty and Ritter (1986)
Beatty and Ritter propose this concept of ex ante uncertainty to explain IPOs underpricing. If most investors have better information, the winner's curse possibly dose not exists
Draho (2001)
Draho also thinks that there is a positive relationship between the ex ante uncertainty and IPOs underpricing,
Liu and Li (2000); Chi and Padgett (2005)
The proxy of offering size is negatively related to initial return.
Chan et al.(2004)
There is a positive relationship between IPOs underpricing and the time between offering and listing date.
Yu and Tse (2006); Ritter, (1991); Megginson and Weiss, (1991)
As for age of a firm, it is inversely related to IPO underpricing
Allen and Faulhaber (1989);
Grinblatt and Hwang(1989)
Underpricing of IPOs can be regarded as a signal of powerful company. That is, a high-quality firm who offers a discount offering is because this firm has the great strength to make up for the losses of new shares undervalued.
Ibbotson (1975), Welch (1989) and Jegadeesh et al. (1993)
The researchers argue that the higher the initial return of IPOs, the bigger the probability of SEO in the future.
Su and Fleisher (1999)
Signaling theory is a strategic mean to signal outside investors the value of company.
2.2 Institutional explanations and IPOs underpricing
Although the asymmetrical information theory has certain explanatory ability to IPOs underpricing, yet the IPOs underpricing may be not necessary to uninformed investors' compensation. If investors have the similar information about new shares, IPOs underpricing can also appear. Some scholars argue that some institutional reasons can interpret the phenomenon on IPOs underpricing.
2.2.1 The lawsuit avoidance
Logue (1973) argues that the companies issuing undervalued shares can reduce legal liability. Underpricing can make up bidders' disappointment to IPOs performance. For example, if bidders know that the closing price of IPOs will increase to 30$, however, offering price still issue at the price of 15$. This is not easy to be sued by shareholders. Also, Tinic (1988) shows that lawsuit fees is not only costly, but also damage the reputation of issuers and underwriters.
Furthermore, all parties when new shares issue undertake legal responsibility. This is called 'due-diligence'. It has been shown that underpricing is inversely related to the extent of due-diligence (Tinic, 1988). Nevertheless, Drake and Vetsuypens (1993) claim that lawsuit risks can not be decreased through IPOs underpricing. They argue that the probability of lawsuit may be the same between purchasers of underpricing and overpricing. Furthermore, according to Alexander (1991，1993), the research indicates that the lawsuit avoidance may be not the primary reason of large-scale IPOs underpricing. In addition, some developing countries' lawsuits can not be obvious, although the degree of IPOs underpricing may be much higher than some developed countries.
2.2.2 Price stabilization hypothesis
Another explanation for IPOs underpricing is the price support theory. Ruud (1993) demonstrates that in order to stabilize the price of after-market IPOs, underwriters tend to issue new shares at a discount price. This solution may reduce the probability of which price of IPOs on the first trading day is lower than the issuing price. It causes that the average initial return is positive on the first trading day. By empirical evidence, Panagos and Papachristou (1993) conclude that price stability theory can reduce the volatility of IPOs returns after going public. However, price support theory may lower the probability of IPOs overpricing. It may prompt underwriters to carry on the book-buliding mechanism if most investors are uninformed (Benveniste et al., 1996). Chowdhry and Nanda (1996) supplement that price stabilization hypothesis is a better measure to handle a winner's curse problem. The biggest beneficiaries are uninformed investors.
2.2.3 Tax argument
The taxation avoid hypothesis is also another explanation of the IPOs underpricing. According to each country's different tax policies, some enterprises may lower the tax revenue though IPOs underpricing, this is the tax argument. Generally speaking, the enterprise needs to make a balance between the IPOs underpricing which brings losses to the enterprise and economical taxes. However, this viewpoint is probably not as a single interpretation of IPOs underpricing.
Table 2.3 Selected studies of institutional explanations
Papers
Findings
Logue(1973)
The companies issuing undervalued shares can reduce legal liability. Underpricing can make up bidders' disappointment to IPOs performance
Tinic(1988)
Lawsuit fees are not only costly, but also damage the reputation of issuers and underwriters.
Drake and Vetsuypens (1993)
Lawsuit risks can not be decreased through IPOs underpricing. They argue that the probability of lawsuit may be the same between purchasers of underpricing and overpricing.
Ruud (1993)
In order to stabilize the price of after-market IPOs, underwriters tend to issue new shares at a discount price.
Panagos and Papachristou (1993)
Price stability theory can reduce the volatility of IPOs returns after going public.
Chowdhry and Nanda (1996)
Price stabilization hypothesis is a better measure to handle a winner's course problem. The biggest beneficiaries are uninformed investors.
2.3 Ownership and control
In this part, it has been discussed from two aspects, retain control and agency problem. Some scholars argue that ownership and control are to some extent two explanations for IPOs underpricing.
2.3.1 Retain control
It is argued that IPOs underpricing may be a method to strengthen managerial control power. The managers usually do not hope an investor who owns large shares. That is because it is likely to threaten managers' control benefits (Brennan and Franks, 1997). The retain control hypothesis proposes there are two kinds of investors in the stock market, namely institutional investors and individual investors. The companies believe the institutional investors may effectively supervise managers after IPOs going public so that enhance the enterprise achievements. Therefore, IPOs underpricing may attract more institutional investors who can hold massive stocks, so that enable the institutional investors to have the enthusiasm to supervise the enterprise. To some extent, IPOs underpricing may make up the institutional investors' costs that engage in the business activity (Stoughton and Zechner, 1998). Also, Grossman and Hart (1980) indicate that ownership dispersion can reduce the occurrence of a hostile takeover and optimize shareholders structure of a company.
2.3.2 Agency problem
There is a potential interest conflict between the agents and the principals. The reason is that the separation of ownership and control. Some minority shareholders may lack of relevant knowledge and experience so that no ability and time to monitor managers. However, in most emerging markets, the company's shares usually are controlled by some major shareholders. Jensen and Meckling (1976) mention that in this case, it is beneficial for minority investors. That is because the major shareholders can more effectively supervise the manager of the company and equity concentration may improve the corporate value. Kang and Shivdasani (1995) claim that companies who are controlled by the major shareholders tend to more quickly restructure after bad performance. Also, Gorton and Schmid (2000) using the Germany corporation data to argue that ownership concentration is helpful to improve the company performance. Furthermore, Claessens and Djankov (1999) indicate that the company of equity concentration may have a strong profitability. The substantial shareholders control the companies, thereby reducing agency costs. However, the massive empirical studies conducted in recent years that although the substantial shareholders can reduce agency costs, it may have the serious agency conflicts with the minority shareholders. For example, the major shareholders do not pay cash dividends and transfer profits through related transactions. These conflicts make the company lose the appeal of small shareholders. For this reason, the market value of this company may be low. Cronqvist and Nilsson (2003) use 309 listed companies in Switzerland. It is estimated that the companies who have controlling shareholders tend to be low market value. Therefore, In order to attract more shareholders, the companies may issue initial shares at a discount price.
Table 2.4 Selected studies of ownership and control
Papers
Findings
Brennan and Franks (1997)
IPOs underpricing may be a method to strengthen managerial control power. The managers usually do not hope an investor who owns large shares. That is because it is likely to threaten managers' control benefits
Grossman and Hart (1980)
Ownership dispersion can reduce the occurrence of a hostile takeover and optimize shareholders structure of a company.
Kang and Shivdasani (1995)
Companies who are controlled by the major shareholders tend to more quickly restructure after bad performance
Gorton and Schmid (2000))
Gorton and Schmid using the German corporation data to argue that ownership concentration is helpful to improve the company performance
Claessens and Djankov (1999)
The company of equity concentration may have a strong profitability. The substantial shareholders control the companies, thereby reducing agency costs.
Cronqvist and Nilsson (2003)
Use 309 listed companies in Switzerland. It is estimated that the companies who have controlling shareholders tend to be low market value.
2.4 Underwriter's reputation and IPOs underpricing
In securities underwriting market, in addition to expertise in securities distribution and marketing, another value for underwriters is that underwriters are the information manufacturers in the issuing market. According to Allen and Faulhaber (1989), although the issuing company before an IPO can disclose some enterprise's value information through various channels, these disclosure of information can not accurately and directly respond the expected value of the enterprise. The information regarding the enterprise's value still retain in the hands of issuing enterprise. Also, Grinblatt and Hwang (1989) argue that the issuing company obviously knows more than outside investors in terms of financial situation, the operating performance and the future cash flow distribution of the issuing company. Therefore, the issuing enterprise can often hold personal information which the massive investors do not know. As IPOs undervalued arising from information asymmetry between the investors and the issuer, if the issuing enterprise would like to reduce IPOs underpricing level, the issuing company may need to reduce the degree of information asymmetrical. Thus, in this process, the underwriter plays a very important role.
The underwriter's prestige may be an important signal for investors. According to Booth and Smith (1986), it has been argued that the underwriters are witnesses of shares pricing. The issuing companies can obtain more investors to companies of quality approval by employing trustworthy underwriters. It is reported that the higher reputation for underwriters tend to choose more stringent standards to appraise the value of initial shares. Thus, the better the reputation of underwriters who determine the price of IPOs, the more accurate reflect to the intrinsic value of issuing companies. Outside investors also understand that underwriters would take into account their reputation when making underwriting decisions. If the underwriters agree to underwrite business, the investors may obtain enterprise's positive signal. Although investors can not directly judge the quality of new public company is good or bad, it can be indirectly determined by the underwriter's reputation. Therefore, companies tend to employ high reputation underwriters to signal valued information of companies to outside investors when companies carry on IPOs. On the other hand, an underwriter may simultaneously underwrite many stocks and there are many potential customers. Therefore, underwriters may set up the prestige through suitable IPOs underpricing, and relies on the prestige to earn more profits.
However, according to Cheah (2000), there is a positive relation between underwriter's reputation and initial return of IPOs. By using Hong Kong's data, it can be found that high reputation underwriters have higher degree of IPOs underpricing. Nevertheless, it is argued that the underwriters who have better reputation may offer relatively lower rate of IPOs underpricing. Carter and Manaster (1990) have conducted the empirical study by using the US's IPOs data in the 1980s. The research shows that the underwriter's prestige has provided the signal of business risk to the market. As small companies with fewer financing have higher risk, as a result, the high prestige's underwriters generally refuse to accept the young and high risk enterprises. Kirkulak and Davis (2005) study the relationship between the reputation of underwriters and IPOs underpricing using Japan's data from 1998 to 2002. It is discovered that the relationship may depend upon the pricing of IPOs and the demand of sale. When the demand is bigger, underwriters' reputation and the degree of IPOs underpricing are positive correlation, otherwise inverse correlation. Carter and Manaster (1990) point out that the high prestige's underwriters issuing low-risk shares is because they expect to obtain income from enterprise's following financing, such as SEO. Carter (1992) indicates enterprises that have no SEO have the high risk after going on the market.
Table 2.5 Selected studies of Underwriter's reputation
Papers
Findings
Booth and Smith (1986)
The underwriters are witnesses of shares pricing. The issuing companies can obtain more investors to companies of quality approval by employing trustworthy underwriters.
Carter and manaster (1990)
The underwriter's prestige has provided the signal of business risk to the market.
Carter (1992)
Enterprises that have no SEO have the high risk after going on the market.
Cheah (2000)
There is a positive relation between underwriter's reputation and initial return of IPOs by using Hong Kong's data,
Kirkulak and Davis (2005)
Kirkulak and Davis study the relationship between the reputation of underwriters and IPOs underpricing using Japan's data from 1998 to 2002. It is discovered that the relationship may depend upon the pricing of IPOs and the demand of sale. When the demand is bigger, underwriters' reputation and the degree of IPOs underpricing are positive correlation, otherwise inverse correlation.
