Determinates of Underperformance

Determinants of underperformance are employed to explain the above-discussed theories. The underperformance phenomenon has been explained using various determinants and proxies by different finance researchers. The following discussion shows how different researchers have used various determinants and proxies to explain the long-run IPO performance.

2.6.2.1 Initial return

Under market overreaction conditions, there is a negative relationship between past and subsequent abnormal returns on individual securities using a holding period of one year or more (De Bondt & Thaler 1987). When investors are overoptimistic as a result of a degree of underpricing, the positive initial return is expected to diminish over time (Omran 2005). Therefore, we can observe a negative relationship between initial excess returns and long-run abnormal returns. Ritter (1991) also found a negative relationship between excess initial return and aftermarket return. This relationship has been reported by many researchers (Abukari & Vijay 2011; Ahmad-Zaluki, Campbell & Goodacre

2007; Cai, Liu & Mase 2008; Chi, Wang & Young 2010; Dimovski & Brooks 2004; Johnston & Madura 2002; Kutsuna, Smith & Smith 2009; Mudambi et al. 2012; Omran 2005). However, a positive relationship between short-run underpricing and long-run performance has been reported in other IPO studies (Álvarez & González 2005; Belghitar & Dixon 2012; Lee, Taylor & Walter 1996). These studies suggested that underpricing signals the quality of the firms and these firms can issue shares in subsequent offerings at a market value price.

2.6.2.2 Operating performance

The operating performance of any firm has a direct influence on its market performance. Chan, Wang and Wei (2004) have argued that stock price performance in the long run in China reflects operating performance and is not purely driven by speculation. They reported that post-issuance stock returns for IPOs of A-shares were positively related to changes in operating cash flows on total assets, changes in sales growth rate and changes in operating return on assets. Chen and Ritter (2000) and Cai, Liu and Mase (2008) also reported that operating performance measures were positively related to long-run performance.

2.6.2.3 Industry

The long-run performance measures of IPOs can be categorised by industry, thus indicating how the long-run performance of IPOs varies in different industries. Ritter (1991) documented that financial institutions outperformed in the market because of the large drop in interest rates in 1985–1986, and oil and gas firms substantially underperformed in the market due to the decline of oil prices during 1981–1983. However, long-run underperformance of IPOs has been reported in all except three industries, and his study concluded that underperformance is more consistent with a ‘fads’ explanation than that of bad luck. Kooli and Suret (2004) also reported that the long-run performance of IPOs varies widely between industries. Their findings indicate that financial IPOs outperform in the long-run market, but mining IPOs underperform for any period in the long-run market. Further, they examined how high initial returns affect the long-run performance of industries. They found that oil and gas IPOs in Canada had high initial returns but very poor aftermarket performance. Moreover, they

documented that, although technology IPOs underperformed over the long run, technology IPOs had among the highest aftermarket performances. In addition, communication and media and merchandising IPOs were also overpriced, indicating less dramatic underperformance than other industries. However, Ahmad-Zaluki, Campbell and Goodacre (2007) documented contradictory findings relative to those of the previous researchers on the long-run performance of Malaysian IPOs. They found that the construction sector outperformed in the long-run IPO market because it had a mean three-year BHAR of +36.28% and a high WR of 1.25, but consumer products, industrial products and properties sectors showed underperformance in the long run. 2.6.2.4 Age of the issuing firm

The age of the firm shows the operating history of the firm. Although firm age (FAGE) has shown a negative relationship with short-run underpricing, Ritter (1991) found a statistically significant positive relationship between long-run performance and FAGE. Further, he explained that poor long-run performance of younger IPOs (higher market- to-book ratio than older firms) can be expected because of the overoptimism and fads hypotheses. Balatbat, Taylor and Walter (2004) also reported a statistically significant positive relationship between the operating history of a company and the company’s long-run performance. This relationship has been reported in many studies in the IPO literature (Belghitar & Dixon 2012). However, an insignificant negative relationship was reported by Brau, Couch and Sutton (2012) and Liu, Uchida and Gao (2012).

2.6.2.5 Years

The year is an important variable to explain long-run performance of IPOs. Ritter (1991) reported a negative relationship between long-run performance and annual volume. He argued that IPO companies decide to go public when investors can pay a high price (high price-earning or market-to-book) and poor long-run performance can be expected because of an unexpected realisation of subsequent net cash flows. Long- run poor performance is consistent with (1) bad lack or (2) irrational overoptimistic forecasts or fads. Chi, Wang and Young (2010) also found a negative relationship between listing year and three-year BHARs. However, Cai, Liu and Mase (2008)

reported a positive relationship for all years with CARs and a negative relationship with BHARs.

2.6.2.6 Original ownership

An IPO forms a significant change in the firm’s ownership structure and results in separation of managerial control and ownership (Wang 2005). The separation of ownership and control creates agency problems between owners and managers. From an agency cost theory viewpoint, a high level of original ownership will lead to a higher value of the firm (Jensen & Meckling 1976). According to the signalling theory, insider ownership sends a signal about the company’s value. Leland and Pyle (1977) suggested that a greater percentage of ownership by insiders is a positive signal about a company, since insiders are assumed to have superior information about expected future cash flows. According to the uncertainty hypothesis, high retention indicates low uncertainty about the quality of the firm and this leads to better performance in the long run (Goergen & Renneboog 2007). Thomadakis, Nounis and Gounopoulos (2012) and Álvarez and González (2005) also found a positive relationship between long-run market performance and ownership retained by original shareholders. This relationship indicates that the original owners retaining more equity capital results in better long-run performance.

2.6.2.7 Issue size

Issue size is normally measured by the total issue capital in terms of dollars. According to past studies, investigations into the relationship between long-run performance and issue size have given contradicting results. Keloharju (1993), How (2000), Goergen and Renneboog (2007), Bird and Yeung (2010), Belghitar and Dixon (2012) and Minardi, Ferrari and Araujo Tavares (2013) found a positive relationship between issue size and long-run performance. This indicates that higher issues perform better in the long run than lower issues. However, Lee, Taylor and Walter (1996), Cai, Liu and Mase (2008), Chorruk and Worthington (2010), Chi, Wang and Young (2010), Liu, Uchida and Gao (2012) and Thomadakis, Nounis and Gounopoulos (2012) have reported a negative relationship with long-run performance. This shows that higher offers perform poorly in the long run compared with lower offers.

2.6.2.8 Hot issue market (HM) and market sentiment (MS)

HM and MS variables are used as proxies to test the window of opportunity hypothesis, expecting a negative relationship with long-run market performance. Thomadakis, Nounis and Gounopoulos (2012) tested the window of opportunity hypothesis using a dummy variable for ‘hot’ issue periods. They found a statistically significant negative relationship between long-run performance and hot issue periods. This relationship has been examined by several researchers (Abukari & Vijay 2011; Bancel & Mittoo 2009; Derrien & Kecskes 2007; Gajewski & Gresse 2006; Lowry 2003). The MS variable was used by Dimovski and Brooks (2004) to test the window of opportunity hypothesis. However, they were unable to find a negative relationship between long-run performance and MS.

2.6.2.9 Market return

MR is another important variable in investigations of the long-run performance of IPOs. Ritter (1991) used this variable to explain long-run performance in the United States and found a highly statistically significant positive relationship with the long-run performance of IPOs. However, he expected that the coefficient of the MR would be greater than 1. The coefficient of the MR indicates the average beta, which is used to measure the market risk. In contrast with Ritter’s finding, Chorruk and Worthington (2010) reported a statistically significant negative relationship between long-run market performance and MR when they used three-year benchmark-adjusted BHARs as the dependent variable and a statistically insignificant negative relationship when they used three-year BHRs as the dependent variable.