DOES IPO GRADING POSITIVELY INFLUENCE RETAIL … · · 2014-04-30 61 ... p. 392) the typical IPO...

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DOES IPO GRADING POSITIVELY INFLUENCE RETAIL INVESTORS?

A QUANTITATIVE STUDY IN INDIAN CAPITAL MARKET

S.Saravanan, Research Scholar, Sathyabama University, Chennai

Dr.R.Satish, Associate Professor, SRR Engineering College, Padur

Abstract

The purpose of this study was to investigate if retail investors have opportunities to gain in

an IPO through IPO grading as a proxy for justifying the quality of the issue. To investigate

the same a cross sectional study was conducted among 140 stocks which were listed

between the periods of 2009 to 2013. Furthermore testing is been done to know the

influence of IPO grading on listing day returns and relationship between listing day returns

and retail investors interest in the stock. Finally we concluded that IPO grading no influence

on retail investors selection of the stock, additionally it’s been found that IPO grading has

positive influence towards listing gain and there is a moderate relationship between retail

investors interest and listing day returns.

Key Words: Initial Public Offers, IPO Grading, Listing day returns

Introduction

An Initial Public Offering (IPO) is the name for the first time a company sells stock to the

public on an official Exchange market. According to Ogden et al. (2003, p. 392) the typical

IPO company is a very young company and has taken a high speculative position in a

growing industry. Furthermore IPOs are among the riskiest equity investments that you can

find the stock market since the company usually has a short earnings history and no history

of public valuation. This results in principal-agent and information asymmetry problems

(Ogden et al. 2003, p. 392).

IPO grading is a service intended to facilitate the assessment of equity issues by unlisted

companies to go public. The grade assigned to any individual issue may represent a relative

appraisal of the fundamentals of that issue relating to the universe of other listed equity

securities in India. In fact IPO grading is positioned as a service that provides an independent




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assessment of fundamentals to assist comparative assessment that would prove useful as

an information and investment tool for prospective investors.

The most significant factor that go in favour of IPO grading are:

1. Professional and independent appraisal

2. Removal of information overload

3. Impediment of weak companies

4. Improving investors’ sophistication

IPO grading covers both internal and external aspects of a company seeking to make an IPO

in general. The internal factors include

1. Competence and effectiveness of the management

2. Profile of promoters

3. Marketing strategies

4. Size and growth of revenues

5. Competitive edge

6. Technology

7. Operating efficiency

8. Liquidity

9. Financial flexibility

10. Asset quality

11. Accounting quality

12. Profitability and hedging of risk

Among external factors the key one is the industry and economic business environment for

the issuer.

SEBI’s Protection measures for retail investors:

1. Retails investors usually see the interest of non-institutional which may create a

artificial demand so SEBI has come with a rule of non-retails cannot withdraw or

downsize the bids.




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2. Emphasis to provide retail discount

3. Additional safety with an option of “Safety Net”

4. Increased minimum three-year pre-tax operating profit requirement from 5 Crores

to 15 Crores

Review of Literature

When looking at previous research on IPOs such as Chemannur et al. (2010) and Chan

(2010) there is a distinction between retail investors and institutional investors and their

role in IPOs. According to Chan (2010) previous literature has established a link between

retail sentiment and the pricing of IPOs shares. Previous literature also suggests that retail

demand on pre-IPO markets reflects the retail investors’ optimism towards the IPO stock

and that pre-IPO market demands are able to predict the short run aftermarket prices (Chan

2010). Furthermore Chan (2010) gives some examples of studies that have documented a

positive relationship between retail investors’ demand for IPO shares and IPOs short term

aftermarket performance, which indicates that retail investors are able to pick high first-day

returns IPOs. Chan (2010) also states that individual investors are subject to sentiment and

sometimes they can be overly optimistic while on other times they can be very pessimistic,

which reflects the pricing on IPOs shares.

The available evidence on the impact of the IPO grading is conflicting. Whereas Deb and

Marisetty (2010), one of the earliest studies on the grading, found that the IPOs after the

introduction of grading is associated with lower underpricing, Khurshed et al. (2011) found

no such role for grading in the underpricing. Further, Khurshed et al., with a larger sample,

found no support for the two key findings of Deb and Marisetty -(i) the high grade issues are

associated with better IPO pricing and (ii) retail investors respond to IPO grading with

increased subscription of the high grade issues. Khurshed et al., instead, argued that the

grading positively influences the subscription pattern of the institutional investors, which in

turn, positively impacts the retail subscription. This close link between the institutional and

retail investors' demands, they have attributed to the evidence of retail investors following

the institutional investors' bids, which is possible due to the high transparency of the book




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building in India. However, the submission of bids by the retail investors towards the end of

the bidding window significantly improves their ability to assess the probability of receiving

allotment. Such an assessment also helps them to reduce the opportunity cost of funds

underlying the application. This behavior would be more salient during the hot periods due

to the greater subscription levels and the availability of more investment opportunities.

These motives of the retail investors imply that 'the retail demand following the institutional

demand' cannot be fully attributed to the information asymmetry faced by the former. It is

somewhat surprising that the IPO grades influence the demand of the relatively more

informed institutional investors rather than that of the individual investors. If the

institutional demand is influenced by the IPO grade, then it is critical to examine whether it

necessarily improves the pricing efficiency in a market like India, where institutions

dominate price discovery and market demand. Partly the results of Deb and Marisetty may

be attributed to the market phase covered by relatively small sample of graded issues (48)

and to the relatively hot period covered by the study where they did not control for the

market conditions. Overall, the available research on the IPO grading is somewhat

conflicting and leaves a number of important questions not adequately addressed. This

paper is a modest attempt to resolve some of the contentious findings on the impact of IPO

grading, given its status as a unique certification in the emerging markets.

Theoretical Framework

Measure of retail Investors interest:

Subscription level of the retail investor’s towards the respective issue is considered as a

proxy to measure their interest towards the IPO Issue.

Calculation of listing day returns:

The initial return is measured as the price change from the offering price and to the market

price within a few weeks of offering date (Ibbotson & Ritter 1995). This is the formula we

use when calculate initial return:

IR = (CP-SP)/SP

IR = Initial Return




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CP = Closing price

SP = Subscription price

If IR is positive the stock has closed with gain on the day (Underpriced)

If IR is negative the stock has closed with loss on the day (Overpriced)

Credit Rating (IPO Grading)

IPO grading is the grade assigned by a Credit Rating Agency registered with SEBI, to the

initial public offering (IPO) of equity shares or any other security which may be converted

into or exchanged with equity shares at a later date. The grade represents a relative

assessment of the fundamentals of that issue in relation to the other listed equity securities

in India. Such grading is generally assigned on a five-point point scale with a higher score

indicating stronger fundamentals and vice versa as below.

IPO grade 1: Poor fundamentals

IPO grade 2: Below-average fundamentals

IPO grade 3: Average fundamentals

IPO grade 4: Above-average fundamentals

IPO grade 5: Strong fundamentals

IPO grading has been introduced as an endeavour to make additional information

available for the investors in order to facilitate their assessment of equity issues offered

through an IPO.

Objectives

1. To identify the relationship between Credit rating of an IPO with Listing day returns

2. To identify the relationship between Credit rating of an IPO with Retail investors

interest

3. To identify the relationship between Retail investors interest with Listing day returns

Research Methodology

Population: Objective of the research paper is to investigate the relationship between credit

ratings with listing day returns and retail investor’s interest. Therefore we have collected

data for 140 IPOs listed from 2009.




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Derivation of Hypotheses: We have developed three hypotheses for testing and they are

formed to answer these questions.

1. Testing of association between credit rating and listing day returns

2. Testing of association between credit rating and retail investors interest

3. Testing of association between retail investors interest and listing day returns

Statistical tool: Chi-Square, Cramer’s V rule to check strength of the association.

Empirical Findings

Credit rating Vs Listing Day returns

Return

Rating gain loss Unavailable

1 6 2 5

2 20 18 5

3 22 24 4

4 23 6 0

5 4 1 0

Table 1- Comparison of listing day returns and IPO grades

Hypothesis 1:

H0: There is no association between credit rating and listing day returns

H1: There is association between credit rating and listing day returns

Chi-Square Tests

Value Df

Asymp. Sig. (2-

sided)

Pearson Chi-Square 25.98043 8 0.001058428

Likelihood Ratio 25.15725 8 0.001461971

Linear-by-Linear

Association 11.86247 1 0.000572765




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N of Valid Cases 140

Table 2- Chi-square for Listing day return Vs IPO grading

p-value of pearson chi-square is lesser than the assumed significance level which implies

reject of null hypothesis.

So there is some association between credit rating and the listing day returns

To analyse how strong the relationship is tested with cramer’s rule.

From the available value of 0.304 relationship is identified to be moderate(Table 3)

Symmetric Measures

Value

Asymp. Std.

Error(a) Approx. T(b) Approx. Sig.

Nominal by Nominal Phi 0.430784 0.001058428

Cramer's V 0.30461 0.001058428

Contingency

Coefficient 0.395635 0.001058428

Interval by Interval Pearson's R -0.29213 0.078490651

-

3.588312522 0.000461277

Ordinal by Ordinal

Spearman

Correlation -0.2629 0.080987798

-

3.200963555 0.001700075


Table 3 – Strength of relationship between IPO grading and Listing day returns




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Chart 1- IPO Grading Vs Listing Day Returns

Credit rating Vs Retail Investors Interest

Subscription

Rating >100% <100%

1 12 1

2 35 8

3 38 12

4 21 8

5 5 0

Table 4- Comparison of Retail investor interest and IPO grades

Hypothesis 2:

H0: There is no association between credit rating and retail investor’s interest

H1: There is association between credit rating and retail investor’s interest




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Chi-Square Tests

Value df

Asymp. Sig. (2-

sided)

Pearson Chi-Square 3.927604146 4 0.415892218

Likelihood Ratio 5.202166926 4 0.267175722

Linear-by-Linear

Association 0.780443673 1 0.377005483


Table 5- Chisquare for IPO Grading Vs Retail investor’s interest

p-value of pearson chi-square is greater than the assumed significance level which implies

accepted of null hypothesis.

So there is no association between credit rating and retail investor interest


From the available value of 0.167 relationship is identified to be very low

Symmetric Measures

Value

Asymp.

Std. Error(a) Approx. T(b) Approx. Sig.

Nominal by Nominal Phi 0.167494 0.415892218

Cramer's V 0.167494 0.415892218

Contingency

Coefficient 0.165193 0.415892218

Interval by Interval Pearson's R 0.074931 0.07470959 0.882725308 0.378919786

Ordinal by Ordinal

Spearman

Correlation 0.085907 0.078208404 1.012922301 0.312869948





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Table 6 – Strength of relationship between IPO grading and Retail investors interest

Chart 2 – IPO grading Vs Retail investors’ interest

Listing Day returns Vs Retail Investors Interest

Subscription

>100% <100%

Gain 65 10

Loss 32 19

Unavailable 14 0

Table 7- Comparison of Listing day returns Vs Retail Investors Interest

Hypothesis 3:

H0: There is no association between listing day returns and retail investor’s interest

H1: There is association between listing day returns and retail investor’s interest




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Chi-Square Tests

Value df

Asymp. Sig. (2-

sided)

Pearson Chi-Square 19.11380196 2 7.07116E-05

Likelihood Ratio 23.25712795 2 8.90797E-06

Linear-by-Linear

Association 0.215964422 1 0.642132181


Table 8: Chi square for Listing day return vs retail investor’s interest

p-value of pearson chi-square is lesser than the assumed significance level which implies

rejection of null hypothesis.

So there is association between listing day returns and retail investor interest


From the available value of 0.369 relationship is identified to be moderate

Symmetric

Measures

Value

Asymp.

Std. Error(a) Approx. T(b) Approx. Sig.

Nominal by

Nominal Phi 0.369496

7.07116E-

05

Cramer's V 0.369496

7.07116E-

05

Contingency

Coefficient 0.346593

7.07116E-

05

Interval by Interval Pearson's R -0.03942 0.073853452 -0.46340519 0.64380399

Ordinal by Ordinal

Spearman

Correlation 0.04552 0.083982072 0.535289768 0.59331106





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Table 9 – Strength of relationship between Retail investors interest and Listing day returns

Chart 3 – Retail investors interest Vs Listing day Returns

Conclusion

Through the conducted test it’s been identified that IPO grading does not creates a positive

influence on retail investors. Nearly 42% of the stocks in which the informed investors has

not shown interest have a good response from retail investors. Also one third of the IPO’s

which had poor of below average credit rating had much interest from retail investors.

Relationship between listing day returns and retail investor’s interest is considered to be

favourable and correlated moderately. Finally there is relationship between credit rating

and listing day returns and again with a moderate level.

References

1. Ritter, J. R. (1991) 'The long-run performance of initial public offerings', Journal of

finance, 3-27.

2. Chemmanur, T. J., Hu, G. and Huang, J. K. (2010) 'The Role of Institutional Investors




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in Initial Public Offerings', Review of Financial Studies, 23(12), 4496-4540.

3. Joshy Jacob and Sobhesh kumar Agarwalla(2012) ‘Mandatory IPO Grading: Does it

help pricing efficiency?’, Indian Institute of Management- Ahmedabad ,Research and

Publications

4. Rock, K. (1986). Why new issues are underpriced. Journal of Financial economics,

15(1):187-212.

5. Loughran. T., Ritter. J. ,2002. Why don't issuers get upset about leaving money on

the table in IPOs? Review of Financial Studies 15, 413-444.

6. Rajan, R. G. (1992) 'Insiders and outsiders: The choice between informed and arm's

length debt', Journal of finance, 1367-1400.

7. Ritter, J. R. (1984) 'The" hot issue" market of 1980', Journal of Business, 215-240.

8. Ritter, J. R. (1987) 'The costs of going public', Journal of Financial Economics, 19(2),

269-281.

DOES IPO GRADING POSITIVELY INFLUENCE RETAIL … · · 2014-04-30 61 ... p. 392) the typical IPO...

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