Consider the elements underlying the movements in Boston Chicken stock, both on the first trading day and subsequently. What made investors so enthusiastic about Boston Chicken shares on that first trading day? Were they subject to heuristic-driven bias? For example, were they betting on trends? To answer this question, consider the following financial highlights, described in Boston Chicken’s prospectus and shown in table 17-1.
Figure 17-1 Stock Price of Boston Chicken, November 8, 1993–January 25, 1999
The roller-coaster ride of Boston Chicken’s stock price, from its offer price on the first day of the IPO through January 1999, including declaring bankruptcy in October 1998.
Table 17-1
Given the figures in table 17-1, trend extrapolation would seem more than a stretch. So, if investors were not basing their optimistic projections on the previous financials, what were they looking at?
The underwriter in the Boston Chicken offering was Merrill Lynch. That year, Merrill Lynch had underwritten two other offerings that had large first-day jumps: indoor-playground operator Discovery Zone, which jumped 61 percent, and golf-club maker Callaway Golf, which jumped 62 percent.
Was there a connection between the Discovery Zone offering and Boston Chicken? Might investors have been basing their projections on the performance of stocks they viewed to be similar? At the time, Robert Natale was emerging-growth analyst for Standard & Poor’s. He appears to have thought so. In a pre-IPO report, Natale noted that the Boston Chicken offering would be hot because of small investors who had profited—or wished they had—from buying stock in Discovery Zone.3
Notice that the possibility of regret looms large here. Put yourself in the position of an investor who cognitively associates the stock of Boston Chicken with the stock of Discovery Zone. Keep in mind that the price of Discovery Zone shares soared 61 percent the day it went public. How badly would you feel if, having missed out on Discovery Zone, you missed buying Boston Chicken shares, the stock price soared on the first day, and you lost out? How much regret would you feel for having failed to act? In hindsight, how obvious would it look to you that you made the wrong decision? If you are prone to regret, then you might have bought Boston Chicken stock on that first day, motivated in part by a desire to avoid blaming yourself if history repeated itself.
In his pre-IPO report, Robert Natale mentions two additional pertinent points. First, the number of Boston Chicken shares being offered was low—less than two million, about 10 percent of the company. This may have contributed to the first-day price advance, with demand for shares being much higher than supply at the offer price. Second, Boston Chicken’s chairman, Scott A. Beck, was a former executive at Blockbuster Entertainment, the video-rental chain, as were other members of management. Given the success of Blockbuster Entertainment around this time, investors may have bet on the Blockbuster Entertainment trend.
Who was buying Boston Chicken stock on that first day? And what were purchasers thinking? An article that appeared on Dow Jones News Service on November 24, 1993, offers some insight:4 “Traders said institutional buyers drove Boston Chicken’s stock early in the day, and most retail brokers were shut out. But desire to buy the hot new offering apparently fired interest in two competing companies, Clucker’s Wood Roasted Chicken Inc. (CLUK) and Pollo Tropical Inc. (POYO).”
Many institutional investors flipped their shares later in the day. But not all. The article quotes Douglas S. Foreman, portfolio manager of Putnam Investment Management’s Specialty Growth Equities Group in Boston, who held on to some of his allocation. He said: “They’ve got a terrific product. Basically, what they’re doing is selling home-cooked meals at fast-food prices.”
Underpricing of the initial offer means that Boston Chicken’s initial shareholders did not benefit directly from the price surge on the initial day. They did not receive even as much as the offer price, given the seven percent or so spread that Merrill Lynch received and the usual expenses associated with going public. In hindsight, underpricing cost Boston Chicken shareholders 50 percent of what they might have received. Why? Because they had to sell a larger fraction of the company than they would have at a higher price to raise the $35.3 million that they did. In other words, the preissue shareholders suffered from a dilution of their ownership in the company.
Case Study 2: Netscape Communications (And Other Internet Stocks)
Some of the most spectacular IPOs have been associated with Internet stocks. This case provides an opportunity to discuss the three IPO phenomena in connection with Internet stocks.
On August 7, 1995, an article with the headline “Market Sees Netscape Most Savory IPO Since Boston Chicken” appeared in the Wall Street Journal.5 Netscape, of course, refers to Netscape Communications Corp. After Netscape and its investment bankers, Morgan Stanley and Hambrecht & Quist, had issued a preliminary prospectus containing an initial offer range and conducted a marketing campaign—in the process acquiring information about investors’ willingness to purchase the issue (bookbuilding)—they were on the verge of setting a final offering price. The next steps would be to issue the final prospectus and wait for SEC clearance before the IPO could become “effective.”
The marketing campaign had generated tremendous interest in the offering. Institutional investors had to be turned away at the New York roadshow luncheon when the room reached capacity at nearly 500. Morgan Stanley, the lead underwriter for the offering, was forced to set up a toll-free number to take requests for information on the deal, while comanager Hambrecht & Quist received more than 1,000 calls a day. In 1995, Robert Strawbridge worked as a summer intern at Hambrecht & Quist. He was put in charge of emptying the San Francisco firm’s voice mailbox. He found his time fully dedicated to listening to investors’ pleas from around the world “People were desperate,” Mr. Strawbridge recalled. “The calls would come in from people saying, ‘I’ve never opened an account before, but this one I have to own. Can someone please, please, call me back?’”
Of course, Morgan Stanley and Hambrecht & Quist were allocating shares to their institutional clients, as well as to some lucky individual investors. And retail brokers were hearing the same kind of pleas. The August 7 Wall Street Journal article mentioned earlier describes a retail broker’s perspective:
“Netscape is going to be a monster—probably one of the best new issues of the year,” said Steven Samblis, an analyst at Empire Financial Group in Longwood, Fla. “I’ve got people calling me and saying, ‘Is there any way I can get this?’ It’s almost impossible for a normal guy to receive an allocation of the new issue, but when the market opens, attack it.”
Samblis said he expected Netscape’s IPO to be priced at about $14 a share with the first trade at about 25. He estimated the stock will go to about 27 the first day and reach the high 30s within 10 days.6
Samblis appears to have been predicting underpricing of the initial offer. Was he right about the amount of the offer price, the fact that it would be too low, and the levels to which the stock would move? Partly. At the time, Netscape did indeed plan to offer 3.5 million shares, including 500,000 to international investors, at $12 to $14. However, two days later, on August 9, underwriters doubled the offer price to $28 per share and increased the size of the offering to 5 million. This change did not exactly prevent initial underpricing: The stock opened at $71, quickly jumped to $72.50—far from Samblis’ prediction of $25—and closed at $58.25—a far cry from $27.
How about predictions concerning long-term underperformance? Consider remarks made by Robert Natale about both the Boston Chicken offering and the Netscape offering. In the November 10, 1993, “Heard on the Street” column, the day after Boston Chicken went public, Natale was quoted as saying: “You’re certainly subscribing to the greater-fool theory if you’re looking for a big upside from here in the next six to nine months.”7
As figure 17-1 shows, Natale turned out to be right on that one. Two years later, the day after Netscape went public, Dow Jones News Service qu
oted Natale on the prospects for Netscape’s stock: “However, Natale warned that Netscape’s stock ‘could tread water for a year or two’ while the company puts its business plan in place, but he believes the stock will move higher.”8 Figure 17-2 depicts the time path of
Figure 17-2 Stock Price of Netscape Communications, August 9, 1995–January 29, 1999
The roller-coaster ride of Netscape Communications’s stock price, from its offer price on the first day of the IPO through January 1999 after being acquired by America Online.
Netscape share prices from August 9, 1995, through January 29, 1999, adjusted for a subsequent 2-for-1 stock split. Was Natale right? Not on this one.
Netscape hardly trod water during the first year it went public. And over the long term it definitely underperformed. On January 6, 1998, the San Francisco Chronicle reported that “stock in Netscape Communications fell 20 percent yesterday after the company, staggered by competition from Microsoft, said it lost money in the fourth quarter and will lay off an undetermined number of workers. … News of the loss and restructuring knocked the wind out of Netscape’s stock, which fell $4.81 to close at $18.56–the lowest since it went public in August 1995.”9
Interestingly, the risk posed by Microsoft had been clearly foreseen in 1995, prior to the offering.10 In any case, the story of Netscape Communications Corp. ended on November 24, 1998, when it was bought by America Online (AOL) for about $4.2 billion.
The last four months of 1998 and beginning of 1999 constituted a very interesting period for IPOs. In early November dozens of companies were postponing or canceling IPOs.11 Then the IPO market turned hot overnight. On November 12, Web page provider theglobe.com set a new record for the biggest first-day gain in IPO history. Starting from an offer price of $9, the stock price soared as high as $97 before closing at $63.50, a 606 percent gain for the day. But the best performing IPO for 1998 was eBay, an online auction service. eBay went public on September 23, 1998, at an offer price of $18, and closed 1998 at $241.25, a 1,240.3 percent increase.12
Was the end of 1998 the beginning of another hot-issue market for IPOs? Certainly several firms went public during these months and experienced rapid price gains; and they were not all Internet firms. So, is there a general hot-issue market phenomenon? Are there times when investors are unduly optimistic about the prospects for IPOs?
The period that began in November 1998 provides a clearer case of a hot-issue market. On Friday, January 15, 1998, financial news provider MarketWatch.com went public. From an offer price of $17 a share, the stock rose to $130, closing the day at $97.50, a first-day gain of 474 percent. This was the second highest first-day gain for an IPO, behind theglobe.com. MarketWatch.com joined the company of five other recent Internet start-ups whose value tripled or more on the first trading day. Is it safe to call these hot issues?
As for the timing of the Netscape IPO, practitioners held different opinions. On one side, we have Robert Natale, who in August 1995 opined that the timing of the Netscape offering was chosen to exploit a hot-issue market. He stated, “Normally, this company would go public in about a year and half when it’s further along in executing its business strategy and earning a profit. But the market is so strong now and the valuation is so high that they’re not waiting.”14 Hugh A. Johnson, chiefmarket strategist at First Albany Corp., shared a similar view. He described instances in which the price of stocks doubled virtually overnight as “one of the many warnings signs that we’ve entered a period of significant speculation.”15
In contrast, David Menlow, president of the IPO Financial Network in Springfield, New Jersey, expressed the view that Netscape’s first-day performance provided no grand insights into the IPO market. “It doesn’t say anything about the IPO market at all. It’s a singular situation and shouldn’t be confused for any frothiness in the market or excessive tendencies of investors.” Others concurred. David Shulman, market strategist at Salomon Brothers Inc., commented that “This does not happen with a market where everything is going up.”
Before turning to the general discussion, the last word goes to Robert Natale,16 already quoted in connection with Boston Chicken and Netscape. Here is his comment on MarketWatch.com:17 “The underwriters priced the deal based on what they thought was fair from a historical perspective. Clearly investors are using a different model.”
General Evidence
Let’s turn from the specific to the general. What about the academic evidence concerning general underpricing, long-term underperformance, and hot-issue markets? And what are possible explanations, behavioral and otherwise?
I begin with initial underpricing. Figure 17-3 below is taken from Jay Ritter (1998). It shows the distribution of first-day returns to IPOs. Clearly, there is a general underpricing phenomenon. Boston Chicken and Netscape may be extreme cases, but they do illustrate the broad phenomenon.
Why is there an underpricing phenomenon? That is, why as a general matter do underwriters set the offer price too low? And why do the shareholders of the firms going public agree to the offer price, given the likelihood that they will lose out? Ritter (1998) offers several possibilities, of which some are behavioral in nature. I begin with one that is not.
One possible explanation is the winner’s curse hypothesis. We encountered the issue of winner’s curse earlier, in our discussion of corporate takeovers (see chapter 16). With IPOs, the question is not
Figure 17-3 Initial Returns (Percentage Return from Offering Price to First Day Close)
Histogram of initial returns (percentage return from offering price to first day close) for 2,866 IPOs in 1990–96. Units, ADRs, REITs, closed-end funds, and small IPOs are excluded. The average initial return is 14.0%. Source:Ritter (1998).
whether investors ignore winner’s curse, but rather whether their recognition of it explains initial underpricing.
Suppose that you are an investor with an investment banking firm that is taking a company public. Suppose the investment bank is the fictitious First Public, the firm is a fictitious company called Softtech, and the date is August 1, 1996, a week before the IPO.
As an investor, you are expecting to receive some allocation of shares at the offer price. Today, August 1, you know neither what your allocation will be, nor what the offer price will be. Suppose that you are not in possession of any nonpublic information about Softtech. However, one week later, you learn the following. The offer price is below the low end of the range described in the initial prospectus, the number of shares to be issued is unchanged from the initial prospectus, and you will receive all of the shares you requested.
Would you view this as good news? Normally, the fact that the price has been lowered should be good news to a potential buyer. But why has the price been lowered? Would you be concerned that the reason you will receive all the shares you requested is that other investors with material information have pulled out? They have pulled out because they know that Softtech is no Netscape. According to the winner’s curse hypothesis, as a smart investor with no material inside information, the only way you would be willing to take a chance on being stuck with a lemon IPO is if First Public underpriced their offerings as a general matter.
A second explanation is the bandwagon, or fad, effect. If investors see that a lot of other investors are interested in an issue, then they may scramble to get on board. Hence, the investment banker may underprice issues in order to induce a bandwagon to form. There are two aspects to the bandwagon effect. First, there is belief that the crowd must know something. Second, misery loves company. Because of the potential for regret, there is safety in numbers. In case of a negative outcome, the pain of regret is mitigated by the fact that many others behaved similarly.
A third explanation is the market feedback hypothesis. Here the investment banker makes an implicit deal with investors during the bookbuilding process. If, during bookbuilding, regular investors truthfully disclose their valuations of the IPO, then the investment banker will reward them by underpricing the o
ffer: the more favorable the valuation, the greater the underpricing.
Think about Netscape. The offer price doubled from $14 to $28 just before Netscape went public, and yet the stock opened at $71 and closed at $58 on its first day. Ritter (1998) reports that the underpricing is greatest when the offer price adjustment, relative to the range mentioned in the initial prospectus, is greatest. Still, Netscape’s investors would have been better off by $174 million18 (before bankers’ fees) had the offer price been $58.25. Why were they so accepting?
Ritter suggests that investors’ accepting attitude stems from their prior expectations. A few weeks before the offering, Netscape shareholders were anticipating that the offer would raise about $50 million.19 Then, just prior to the offer, the offer price was doubled and the number of shares issued increased. So, instead of raising $50 million, they ended up raising $161 million (less fees).
There is an issue of frame dependence lurking here. Suppose that the total size of the value to be captured by Netscape shareholders on August 9, 1995, was $335 million. Shareholders had set themselves a reference point of $50 million. Hence, the $335 million was segregated into three pieces: the reference amount of $50 million, the additional in-the-pocket gain of$111 million, and the opportunity loss of$174 million. As noted elsewhere, it is a standard behavioral finding that psychologically, in-the-pocket amounts loom much larger than opportunity amounts (Thaler 1991). Therefore, investors react much more strongly to the reference amount and in-the-pocket “gravy” than the opportunity loss. Consequently, they evaluate the resulting combination quite favorably.
Beyond Greed and Fear Page 31