Some Behavioral Issues in Indian IPOs

It is believed that about one hundred IPOs (Initial public offerings) with an expected size of around Rs. 50,000 crore are expected to land in the Indian stock market during the year 2011. The head of the investment banking arm of one of the multinational banks is quoted as saying that the year 2011 will see a massive bunch of issues hit the market unlike before and the issuers will have to price their trade more sensibly to attract investor attention [sic.]. Whenever it comes to participate in IPOs, investors see their adrenaline rush as they are believed to be searching for a "good" bet. It has been observed that investors are choosing companies to bid for in IPOs and are avoiding highly-priced IPOs. But it is also seen that they are bidding overwhelmingly in attractively-priced issues in the past such as CIL (Coal India Limited) and MOIL (MOIL Limited, formerly Manganese Ore India Limited). Experts say that it is a practice that shares of government enterprises are priced lower than their counterparts in private sector, while the price of shares of companies in private sector is usually determined above that of their peers. Though this practice has led come poor response and losses for investors, but no choice!

Renowned economist Hersh Shefrin who has done pioneering works in the area of behavioral finance identified three behavioral phenomena associated with initial public offerings (IPOs) as initial underpricing, long-term underperformance, and  "hot issue" market. In any IPO, there are three main parties involved in the offering: the issuing firm, the underwriter, and investors. Although the role of all stakeholders is important, the issue of concern here is the role of investors who are the most prone to any (and in fact, many) behavioral biases.

Image courtesy: India-commodity.com

The three behavioral phenomena namely, initial underpricing, long-term underperformance, and "hot issue" market, are against the principles of the efficient market hypothesis (EMH) which asserts that stock markets are 'informationally efficient', and has been in the central proposition of finance since early 70s. These phenomena mostly occurs in tandem. Issuers keep their offer price too low in order to attract large pool of investors. Thus the issue will be underpriced and initial underpricing occurs. Companies try to offer the initial issue at a very attractive price, as we can see in past cases including SKS Microfinance, Punjab & Sindh Bank, CIL, and MOIL. It is expected that private companies such as Jindal Power and Sterlite Energy which are planning to come up with their IPOs during the year 2011 can have a lower valuations as investors might turn choosy, having profited from attractively-priced state-owned companies' issues in the recent past.

When the issue is underpriced and it is deemed to be an attractive offer, it leads to an excessive first-day trading, subsequently its price will soar on the first trading day. But as the EMH rules the market to some extent, the market will get to know the company's fundamentals. In case the price overshoots fundamental value, the price will fall back over time as soon as the market assesses the fundamentals right. This phenomenon was seen in case of the offers of Claris Lifesciences and AtoZ Engineering, when investors shunned the initial price shoots up shortly after the first-trading day. The decline in share prices under this situations will give rise to long-term underperformance of that share.

Image courtsey: nsdl.co.in

With such sharp fluctuations in share prices immediately after the initial public offering, IPO activity also tend to move in hot and cold cycles. When the investors' demand for any IPOs is very high, that state of market can be called as a hot issue market. A very interesting example of such nature is the initial public offering of Reliance Power in the beginning of the year 2008. When the issue for Reliance Power shares with a price band  of Rs. 405- Rs. 450, closes on 18th January 2008, investors had bid for as many as 72 times the number of shares that the company offered on the block under its IPO. Investors had put in bids for over 1,654.8 crores shares as against the 22.8 crore shares on offer. The demand for the shares was such that almost every single person in the street (with the capability of invest the minimum required money into those shares) was rushing to get a demat accout so that he would not miss the opportunity. Sources in media reported that  National Securities Depository Ltd. (NSDL) has shown that the number of active account grew from 5.22 lakh during July-September 2007 to 7.25 lakh during October-December 2007. Something similar happened at another depository CDSL where the number grew even more dramatically from 3.8 lakh in third quarter to 6.9 lakh in the fourth quarter of 2007. An official of one of the major stock broking houses said, "Since the Reliance IPO was announced, there is a line outside every DP office and hundreds of application forms are pending and it seems like a mad rush of people wanting to open demat accounts." Somewhat similar phenomena was seen when the IPO of CIL was on offer. These times are referred to as a hot issue market when investors' IPO-adrenaline rush to track a best bet.

The issuers while going public always hope to obtain the best price for their shares that they can. Therefore, it will be in their interest if they time their issue (of IPO) for when sentiment is positive and investors are particularly optimistic. The evidences for hot markets (as earlier discussed also) is actually strong. Though research has shown that both investors and managers are unduly optimistic about the future prospects of the issuing firm (Loughran & Ritter, 2004). A word of caution for investors: take a note of these behavioral phenomena associated with IPOs! During the year 2011, a large number of initial public offerings are expected to come, and also they are supposed to be attractively priced, for sure. IPOs such as Delhi Metro Rail Corporation (DMRC), Reliance Life, Super Religare Laboratories (SRL), and HDFC Life are of especial interest for investors. Let's wait and watch if these phenomena persist in the market and if yes, to what extent.