Zakaria S.G.

Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering

Perspective, Ph.D. thesis, Strathclyde University, U.K.

2.2.5 EXPLANATIONS OF THE LONG-RUN PRICE PERFORMANCE OF IPOS

In this section, a conceptual background relevant to the price performance of

the IPOs in the long-run is provided. The survey revealed some hypotheses suggested

in explaining the aftermarket performance of the IPOs; namely:

1. The divergence of opinion hypothesis;

2. The insiders-dumping hypothesis;

3. The efficient market hypothesis;

4. The impresario hypothesis;

5. The windows opportunities hypothesis;

6. The speculative bubble hypothesis; and

7. The seasoning effect hypothesis.

Briefly, each of these hypotheses is reviewed as follows:

2.2.5.1 The Divergence of Opinion Hypothesis

The present hypothesis predicts that if there is a great deal of uncertainty

about the value of an IPO the evaluations of optimistic investors may be much higher

than those of pessimistic investors. As time goes on and more information becomes

available, the divergence of opinion between optimistic and pessimistic investors will

narrow, and consequently, the market price will drop.

For this reason, Miller (1977) argues that investors who are most

opportunistic about IPO will be the buyers and he predicts that IPOs will

underperform in the long-run. Miller (1977), explained his prediction by curve ABC

plotted in Figure 2-2 below. This figure shows the cumulative distribution of the

number of investors with estimates above a certain value for the amount received at

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Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

liquidation of the investment. It can also be interpreted as the number of shares

investors are willing to hold at each price.

Figure 2-4 The cumulative distribution of the number of

investors with estimate above a certain value for the amount
received at liquidation of investment.

A F
D D
Q
R
Estimate
of M B
Value G H

E
J C
Number of investors
N
Number of investors

Source: Miller (1977:1152).

Miller (1977) assumes that:

 Any single investor is able to purchase only one share and there are N shares

available.

 The shares will end up being owned by the N investors with the highest

evaluation of the return.

From curve ABC it can be seen that:

 There are N investors who estimate the final value to be R or above.

 The selling price of the stock will be R.

 If it was lower,

- there would be more than N investors who wished to hold the stock, and

- bidding against each other they would soon bid the stock up to R.

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Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

 If it was above,

- some of those holding the security would feel it over valued, and

- would attempt to sell their share, driving the price back down to R.

 The curve ABC in Figure 2-4 is a demand curve for the security. The supply

curve is a vertical line at the number of shares available.

 The price is determined by the interaction of the demand and the supply curves.

Several results follow from this simple model. As long as the entire supply of

the security can be absorbed by a minority of the potential purchasers the market

price will be above the mean evaluation of the potential investors. Also as long as a

minority of potential investors can absorb the issue, an increase in the divergence of

opinion will increase the market clearing up. This can be seen by noting that:

 If curve ABC is replaced with curve FBJ, representing a greater divergence of

opinions about the security. The market clearing price rises from R to Q.

 On the other hand, if the divergence of opinion decreases, causing curve ABC to

be replaced with curve GBE, the market clearing price falls from R to M.

 In the limit, where there is no disagreement about the return from the security,

curve ABC becomes the straight line GBH, and the market price falls to G. Only

in this case is the market price determined by the average evaluation of the

potential investors (Miller 1977:1152-53).

Direct evidence does support Miller’s prediction that many investors are periodically

overoptimistic about companies. For example, Shiller (1990) provides evidence via a

survey of investors of IPOs, that only 26 % of the respondents in his sample did

some fundamental analysis of the relation between the offer period and the firm's

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Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

underlying value. Moreover, Jain and Kini (1994) provide evidence that the earnings

per share of companies going public actually declined in the first few years after the

IPO [see Figure 2-5].

Figure 2-5 Market Expectations and Earnings Performance

5
4.5
4
Earning per share

3.5
3
2.5
2
1.5
1
0.5
0
0 1 2 3 4 5
IPO sample Ind sample Year relative to IPO

Source: Jain and Kini (1994: 1724)

2.2.5.2 The Insiders-Dumping Hypothesis

A further explanation considers the possibility that after an initial price

increase for underpricing, stock prices might fall in the aftermarket due to the effects

of insiders-dumping on listings. The present hypothesis implies that a downward

sloping demand curve for a firm’s stock exists so that an increase in the supply of

stock leads to a stock price decline [see Myers and Majluf (1984) and Greenwald,

Stiglitz and Weiss (1984)].

Direct evidence does not support the hypothesis that insiders may dump their

stock on listing, causing a large increase in the supply of stocks on the market. The

empirical results of McConnel and Sanger (1987) do not confirm such explanation.

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 Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

Table 2-27 illustrates the results of investigating the insider-dumping explanation of

negative post-listing returns in the work of McConnel and Sanger (1987).

Table 2-27 Average monthly raw returns and average monthly market-adjusted returns
following listing for 305 common stocks that listed on the NYSE over the period 1973-
1978 categorised according to volume of insider trading
Sample in which insider Sample in which insider Sample in which no
sales exceeded insider purchases exceeded insider trade were
purchases insider sales reported
(sample size = 48) (sample size = 66) (sample size =191)
Time interval Average Average market Average Average market Average Average market
following raw return adjusted returna raw return adjusted returna raw return adjusted returna
(percent) (percent) (percent) (percent (percent) (percent
listing
First month 194 0.62 0.64 -1.33 -1.34 -2.04
(0.33) (-0.79) (-2.46)*
Second month 1.68 1.47 -1.22 -2.75 1.42 0.41
(1.00) (-2.11)* (0.57)
Third through 0.29 -0.63 1.32 0.29 0.87 0.02
twelfth (-1.22) (0.56) (0.77)
months
Source: McConnel and Sanger (1987).
a t-statistic to test the null hypothesis that the average market-adjusted return equal to zero is contained in parentheses.
* Significance at the 0.05 level.

In this table, of the 305 firms examined, only 48 were classified as having net

insider sales, while 66 were classified as having net insider purchases. Almost two

thirds (191) of the companies experienced no insider trading activity. Contrary to the

insider-dumping explanation of negative post-offering returns, for the 'net insider-

sales' group, the first- and second -month average raw and market-adjusted returns

are positive although not statistically significant. For the 'net-insider-purchases'

group, the first-month average raw return is negative and both the first- and second-

month market-adjusted returns are negative. Only the second month market-adjusted

return is statistically significantly different from zero. Finally, only the 'no-insider-

trading group exhibits negative average raw return in the first month following

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Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

listing, and only for this sample is the market-adjusted return statistically

significantly different from zero.

The results of the analysis led no support to the insider-dumping explanation

of negative post-listing stock returns. To the contrary, of the firms examined, in the

work of McConnel and Sanger (1987), those that experienced net insider selling

earned higher average returns following listing than those firms with either net

insider purchases or no insider activity. As a result, it may be suggested that insider

selling can not explain negative post-listing stock-returns.

2.2.5.3 The Efficient Market Hypothesis

In its weak-form version, the Efficient Market Hypothesis (EMH) predicts

that all information regarding past price movements are reflected in the current stock

price. This form of the EMH can be supported by a confirmation of the random walk

theory upon which stock price changes are independent over time [see Levy and

Sarnat (1984), and Hudson ; Dempsey and Keasey (1996)]. Thus, the return from any

initial underpricing should also be independent of subsequent returns [see McDonald

and Fisher (1972) and Ibbotson (1975)]. Moreover, the weak-form of the EMH

suggests that it is not possible to establish profitable trading rules based on the prior

performance of a share.

For example, if a new issue performs well initially, there is no reason to

believe that its subsequent performance will be superior or inferior. If such

predictions were possible, profitable trading rules could be established thus

invalidating the EMH [see Ibbotson and Jaffe (1975), Block and Stanley (1980),

Ibbotson (1975), Logue (1973), McDonald and Fisher (1972), Neuberger and

Hammond (1974), and Fischer and Jordan (1991)].

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Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

In brief, the EMH suggests that underpricing in the IPOs is associated with

initial mispricing and that stock prices adjust to their true level in early trading to

remove this underpricing. As a consequence, high returns would not be attainable, on

a continuous basis, over the longer term. Eventually, this hypothesis is supported in

the present thesis.

2.2.5.4 The Impresario Hypothesis

Shiller (1990) presents an 'impresario' hypothesis in which he argues that the

market for IPOs is subject to fads and that IPOs are underpriced by investment

bankers (the impresarios) to create the appearance of excess demand. Sheller's

hypothesis predicts that companies with highest initial return, should have the lowest

subsequent returns. There is some evidence of this relation in Ritter (1991), [see

Section 2.2.2].

2.2.5.5 The Windows Opportunities Hypothesis

Ritter (1991) and Laughran and Ritter (1995) argue that the low long-run

returns on IPOs are consistent with issues taking advantage of 'windows of

opportunity' in which the market is willing to overpay for their equity. This

framework can be viewed as a dynamic version of Myer's (1984) financing

hierarchy, or pecking order framework. In the static financing hierarchy model,

external equity is always the last choice for financing. In the dynamic financing

hierarchy, or windows of opportunity, model, external equity is sometimes the first

choice for financing, because sometimes a firm can issue overvalued equity. The

windows opportunity framework predicts that this will be low long-run returns on

firms conducting IPOs and on firms conducting seasoned equity offerings.

2.2.5.6 The Speculative Bubble Hypothesis

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Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

This hypothesis suggests that there is a possibility of emerging ‘speculative

bubbles’ in the aftermarket because the market exaggerates the increase of prices in

order to compensate for the perceived level of initial underpricing in the IPOs. An

optimism may also emerge in response to an issue being oversubscribed prior to

trading so that investors unable to purchase the stock, at that time of issue, may

increase demand for the stock in aftermarket trading and add to the increase in the

stock price. At length, however, because the market efficiency causes investors’

expectations to be revised, so that stock prices adjust downwards to their ‘true’ level,

then, this ‘speculative bubble’ will burst.

Direct evidence supports the existence of such phenomenon in the U.S..

Aggarwal and Rivoli (1990) note that such bubbles burst between five and twelve

months following the initial offering. More importantly, investors buying stocks after

the reaction to the initial underpricing are likely to experience negative returns as

investors revise the stock price downwards as progress is made through the

aftermarket in the IPOs.

2.2.5.7 Seasoning Effect Hypothesis

The final explanation in our survey suggests that adjustment for initial

underpricing might be gradual and continues in the aftermarket leading to an increase

in stock prices over time. Reilly and Hatfield (1969) noted that the long-run increase

in stock price as being a gradual and continued adjustment for underpricing. Reilly

and Hatfield argued that this continuing price rise may also be consistent with a

gradual reduction in the shares’ perceived level of risk as they become seasoned.

However, a somewhat different interpretation might be that a gradual and continued

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Zakaria S.G.Hegazy: Egyptian Stock Market Efficiency: An Initial Public Offering
Perspective, Ph.D. thesis, Strathclyde University, U.K.

increase in stock price is related to an emerging of favourable information over the

aftermarket period in the stock.

2.3 SUMMARY

In this chapter, a substantial body of facts and information has been recorded

within the literature review concerning the price performance of the IPOs. These

facts and information were analysed in two sections. The first section focused on the

levels, measurement methods, time intervals and explanations reported in prior

studies for initial returns of IPOs. Then, the second section dealt with examining the

performance of IPOs over the long-run periods of trading.

In conclusion, one can point out that:

 The poor-performance of IPOs in the long-run makes the new issues underpricing

phenomenon even more of a puzzle.

 The questions of whether or not IPOs underperform in the long-run as well as

why issuers set their IPO price at a level that is lower on average than the market

price at the end of the first day have generated a large literature.

 There is no specific model can provide a definitive explanation of the these

anomalies (i.e., short-run underpricing and long-run overpricing].

 The evidence of long-run returns for IPO is less extensive (both temporally and

internationally) than evidence of underpricing.

 Explanations for poor-abnormal returns in the aftermarket are relatively less

developed than those for initial returns.

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Perspective, Ph.D. thesis, Strathclyde University, U.K.

 The evidence of underpricing and long-run performance of the IPOs have been

well documented in the developed stock markets, however, it is not the case for

developing capital markets.

 The majority of the literature focuses on the private IPOs, whereas the

privatisation sales in the emerging markets get only a small consideration.

Therefore, due to the limited international evidence of long-run performance

by IPO, further analysis is warranted, especially in terms of the relationship between

initial and long run returns. Thus, the main objective of the following chapters is to

examine the price performance and capital market efficiency in the Egyptian stock

market with specific concentration on the privatisation sales over the period 1994-96.

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