0:14
Let's start with
underpricing, which is
probably the most interesting one.
Again, what did we see?
We saw Twitter was
offered at $26 a share,
and it closed on the first day of
trading at roughly $45 a share.
So, investors that were able to buy
at $26 a share made a lot of money.
We saw from Jay Ritter's
information that he
collected that IPO initial returns
on average are roughly 18%.
So, even if you didn't get the
70 plus percent rate of return
associated with buying the Twitter
IPO, if you just buy a typical IPO,
you're making a pretty
good amount of money
over a very, very
short period of time.
So, what I want to talk about is
this Rock winner's curse model.
It was published back
in 1986, and by the way
there's going to be a list of
all these papers and citations,
and you'll be able to see these
articles and where to find them.
So, the Rock winner's
curse model basically
notes that IPOs are underpriced.
If you can buy at the
initial offering price,
you can make a pretty
good amount of money.
If we think about the
18%, on average IPOs
are underpriced by 18%,
but that's just on average.
Some IPOs are underpriced
by much more than 18%,
Twitter was an example.
But a lot of IPOs have
lower initial returns,
and a significant number
of those are negative.
So, on average you make 18%,
sometimes more, sometimes less,
Rock points out, and this makes
sense, that there are two types
of participants in the IPO market.
There are informed investors,
people that have a pretty good feel
for what these IPO
stocks are really worth,
and maybe a bunch of
uninformed investors
that don't have a good feel
for what the stock is worth.
The question is if I'm
uninformed, if I don't bother
to do any research and I just
simply say, look, IPOs in general
make 18%, I'll just buy
a whole bunch of them.
And through the process
of diversification,
sometimes I make more,
sometimes I make less.
And I'll just make 18% on
average, that's a really good rate
of return, so I'll just
participate in the IPO market
simply by buying every single
IPO that I see out there.
Does that work?
Will I earn 18% on
average by placing
orders to buy every single IPO?
There's a problem with that.
A lot of IPOs are
oversubscribed, meaning
that, going back to
the Twitter IPO, you
might have orders to purchase
many, many more shares
than the 70 million being offered.
You might have, say 140 million
shares that people want to buy,
and only 70 million
that are being issued.
So you have oversubscription.
The question is, what you do
when you have oversubscription?
So, maybe the fairest thing to
do is have a pro-rata allocation.
So, if there is 140 million
shares bid for, requested,
and 70 million shares being
sold, you just give everyone
half of what they requested.
So if I requested 200
shares, I get 100 shares.
The problem is that if you have
informed and uninformed investors
out there, the uninformed investors
are just making bids to purchase
every single IPO, but
the informed investors
are only placing orders
to purchase what they
view to be the underpriced IPOs.
So, they would look
at Twitter and say,
that's likely to be an underpriced
IPO I'm going to purchase
that particular offering.
But an offering that
I think is overpriced,
I'm not going to place
a bid to buy that.
So what ends up happening is
uninformed investors receive
very, very large allocations.
They receive close to
their requested allocation
for the overpriced IPOs,
and very small allocations
for the underpriced IPOs.
Basically, they're crowded
out by the informed investors.
So, they're not
making 18% on average,
they're getting a large portion of
the overpriced IPOs, where they're
losing money, and a very low
allocation on the underpriced IPOs,
where they make money.
Rock assumes there's not
enough informed investors
to meet demand of the IPO market.
Basically, you need uninformed
investors to complete the market.
So, why do you have underpricing?
You have underpricing
on average to induce
uninformed investors participate.
You need to underprice
because of this allocation
schedule where they get a larger
proportion of the bad offering.
So, you need to underprice
on average so that at least
they break even on their purchases.
