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Posted
3/6/2003
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The
Speculator
Recent
articles:
• Don't be lured into
an IPO con game, 2/27/2003
• Commission-free
trades and other scams, 2/20/2003
• Why a bad golfer
makes a better CEO, 2/13/2003
More...
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The
Speculator
The IPO pickings
are slim -- but profitable
Initial public offerings are a hard sell these
days, but that may mean a better deal for investors. While the total
numbers are way down, we found that the payoff still beats the Nasdaq by a
mile.
By
Victor
Niederhoffer and Laurel Kenner
The
time is right to study and buy initial public offerings. The main reason is
that IPOs are as rare right now as a rise in the Nasdaq -- down from 556 in
1999 to 161 in 2002.
Because
IPOs are both rare and difficult to sell in today’s risk-averse market,
they have to be priced on very attractive terms. Let’s go behind the scenes
to a pricing session at a typical IPO negotiation between investment bank
and company.
The
company wants to receive as much money as possible so it can carry out its
mission. The underwriter, while wanting to win the business, must deal with
an investor clientele. Those clients want the issue priced low enough to
compensate them for the bad fortunes they’ve had recently and the
extraordinary risk that all IPOs represent. Institutional clients want a
profit big enough to attract investors back into a mutual fund. Individual
clients want the 100% profits they became accustomed in the 1990s.
Both
sides jockey for short- and long-term advantage. During the 1990s, the
negotiations often ended with the company agreeing to a price that would
generate an expected return for the investors of about 40% a year
compounded for the next five years, with an additional 10% reduction in the
offering price “to make it attractive to institutional customers.”
Imagine
the extra inducement that companies desperate for expansion funds must
offer to such customers nowadays. How about a return of 70% to 80%?
But
this is just a hypothesis, and the Speculators do not like to guess without
testing their guess with the proverbial pencil and back of the envelope.
This time, our desire to test was particularly pronounced because we were
precluded from doing so by the extraordinary extravagance of the tapestry
of big cons and “free lunches” in the IPO market detailed in our last two
columns. (To read them, click here and here.)
To
benefit our readers and to remedy our frustration over the lack of counting
in previous weeks, we decided that a complete enumeration of every IPO in
the last four years was in order.
The IPO headcount
We
looked at all U.S. offerings where the company was the sole issuer, while
excluding mutual funds and closed-end offerings from the totals we listed
above. We calculated the return from the offering price through the end of
the year of the issue and the next calendar year. (We included 1999, one of
the best years in stock market history, as a point of comparison. In that
year, many IPOs opened and remained more than 100% over their offering
price -- giving little opportunity for typical investors to take
advantage.) For companies that went public in 2002, we reported the results
through year-end.
We
then compared the results to the average performance of the Nasdaq
Composite Index ($COMPX) in the comparable periods. For
instance, if a stock went public on March 1, 1999, the comparable Nasdaq
performance period for the year was March 1, 1999 to Dec. 31, 2000.
Guess
what? The results amply confirmed our thinking.
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Outperformance of IPOs vs. Nasdaq Composite
(difference in percentage points)
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1999
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2000
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2001
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2002
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Average IPO
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186%
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-14%
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15%
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0%
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Average Nasdaq performance for comparable periods
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50%
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-37%
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-5%
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-13%
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Outperformance
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136
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23
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20
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13
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Standard Deviation
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270%
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65%
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45%
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33%
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# of observations
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461
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360
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85
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80
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As
the table shows, IPOs substantially outperformed the Nasdaq in each of the
past four years. The margin of superiority was 136 percentage points for
1999 IPOs, 23 percentage points for 2000 IPOs, and -- so far -- 20
percentage points and 13 percentage points, respectively, for the classes
of 2001 and 2002.
Note,
however, that the 23 percentage-point superior performance of IPOs in 2000
still left holders of IPOs with a return of -14%. Similarly, in 2002,
although the IPOs performed 13 percentage points better than the Nasdaq,
their actual performance was zero since the Nasdaq itself was down 13% in
the comparable period.
Investors
who believe in the results and wish to lock in the return can do so buying
a basket of IPOs and shorting the Nasdaq against it. This can be
accomplished with the Nasdaq 100 E-mini futures listed on the Chicago
Mercantile Exchange, or with the Nasdaq-100 Trust tracking stock (QQQ), an exchange-traded fund on the
American Stock Exchange.
Considering
that 986 companies were involved in IPOs during those four years, the
superiority of the IPOs to the Nasdaq is a highly non-random phenomenon --
one that is approximately a 1-in-10 million shot by chance alone.
But don't IPOs underform?
Our
IPO results are completely opposite to the accepted conclusions of the
academic literature. Numerous studies show that the path of an IPO is to
show superior performance on the day of the offering and then to decline
abysmally in the five years thereafter. For both the U.S. and foreign
markets, the total inferior performance of IPOs over their next five years
is about 30 percentage points.
But
isn’t it always the case that the academics are behind the form? It is just
when the professors have unanimously concluded that a market is
ridiculously risky and performing dismally, based on data that was old to
begin with and has aged even more during the typical multiyear peer review,
that the investor is best compensated for taking the opposite position.
Our
results are confirmed by the Bloomberg IPO Index, a capitalization-weighted
index of the performance of all IPOs during their first public year. The
index rose from 476 at year-end 1998 to 861 as of March 3, 2003. This is a
gain of 81% vs. a decline of 40% in the Nasdaq during the comparable
period. Year by year, here is how both indexes performed:
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Performance of IPOs vs. Nasdaq by year
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Year
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IPO
Index
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Nasdaq
Composite
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1999
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256%
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86%
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2000
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-45%
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-39%
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2001
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-1.5%
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-21%
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2002
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-0.3% (incomplete)
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-32%
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The
IPO Index is up 6% from mid-2001, versus a staggering 39% decline in the
Nasdaq during the period.
Make more out of a good thing
A
good winner quietly departs after the victory. We will follow this model
ourselves. But there is just one more thing.
Recent
IPOs have shown a superior performance of approximately 18% better than the
Nasdaq. Are there ways to improve on that? One way is to look at accounts
receivable and IPOs, a strategy we discussed in our last column, ”Don't be lured into an IPO con game.”
Another regularity that academics have found relates to the superior
performance of IPOs priced at whole numbers -- 15 or 16, say, rather than
15 3/8 or 16 1/4.
A
draft paper, “Negotiation and the IPO Offer Price: A Comparison of Integer
versus Non-Integer IPOs” by Daniel J. Bradley, John W. Cooney Jr., Bradford
D. Jordan and Ajai K. Singh found that of 4,523 IPOs between 1981 and 2002,
three-fourths had integer offering prices. These showed an average
first-day return of 25% vs. just 8% for the non-integer offerings. The
authors attributed this to the additional uncertainty and therefore higher
required returns of integer-priced IPOs as compared to the fractional ones.
We
could not resist trying to replicate this finding by testing it on our
sample of 986 IPOs for 1999-2002. The results were interesting but insignificant.
The integer edge in the years 1999, 2000, 2001, 2002 was, respectively:
173%, -1%, 0, and 3%. However, note that there were only 28 non-integer
companies that went public in the heady days of 1999, versus 433 integer
companies.
Next up on the IPO front
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In the last three months, 15 IPOs have been priced
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Company
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Ticker*
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Lead
manager
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American Financial Realty
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AFR
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BAS, FBR
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Intervideo
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IZII
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SG Cowen
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Telkom South Afr
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TKG
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Deutsche Bank/J.P. Morgan
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DigitalNet Holdings
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DNET
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BAS,SSB
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Ipass
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IPAS
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CSFB/Morgan Stanley
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Sandalwood Lodging
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SND
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Emerald Bay Capital
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Nicholas Applegate Convertibles
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NCV
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UBS Warburg
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Redline Performance Vehicles
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RED
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Gunnallen Finl
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State Street
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SBZ
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Goldman Sachs
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Yamhill Valley Vineyards
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WINE
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Paulson Invt
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Molina Healthcare
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MOH
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BAS,CIBCWM
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Endurance Specialty Holdings
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ENH
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Goldman, Merrill
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Todco-A
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THE
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Morgan Stanley
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Converse
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CNVS
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Morgan Stanley
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iPayment
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IPMT
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Bear Stearns
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*These are the expected symbols; most do not yet work
in the MSN Money database.
Final note
We
wish to thank Shi Zhang for his research support on this project. A
complete workout of our results is available on our Web
site. Please send your IPO stories to us at gbuch@bloomberg.net.
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