The The IPO Trading System & Strategy has baffled academics for several decades and is the result of three unusual price patterns that are typically associated with new public stock offerings:
- The first day of trading for new IPOs sees abnormal returns
- IPOs typically under perform over the longer term
- IPO under performance moves in cycles
According to Mahjoub, by the end of the first day of trading, US IPOs between 1990-2007 traded on average 18.9% above their offer price at which the company sold them.
This pattern of under-pricing also held strongly in the 1960s (21.2%), 70s (9%) and 80s (8.2%).
But it reached its peak in the Internet bubble of 1999-2000 where an estimated $66.63 billion was left on the table based on the starting price of US IPOs in that time period.
Meanwhile, separate research from Jenkinson and Ritter seems to illustrate that this anomaly is a global phenomenon:
The abnormal returns for IPOs on the first day of trading is another rejection of the efficient market hypothesis and a number of explanations have been put forward for its existence.
Some authors argue that issuers voluntarily leave money on the table in order to create a nice start and good feeling among new investors in the stock and therefore allowing issuers to have more successful Seasoned Equity Offerings in the future.
Others argue that IPO under-pricing can act as risk compensation for the underwriter. One other study found that banks can lose IPO market share if they under-price or overprice too much (Dunbar).
To go alongside this anomaly, there is also evidence that IPOs go on to perform worse than the market overall. So it seems IPOs typically return above average returns on the first day of trading but then go on to under-perform.
In analysis of US IPOs between 1970-2010 Ritter found that equal weighted returns for IPOs were -4.8% in the first year, -8.1% in the second year and -3.3% over five years. This is well under benchmark returns.
Whatever the explanations, there do seem to be anomalies persistent in IPOs that could be available for the average investor to take advantage of.
The The IPO Trading System & Strategy:
More research may be needed but the general strategy is to go long IPO stocks on their first trading day. You can also short IPO stocks to capture under performance in subsequent years.