INVESTOR EXPECTATIONS ON RETURN AND...

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International Journal of Management (IJM)

Volume 7, Issue 3, March-April 2016, pp. 172–184, Article ID: IJM_07_03_016

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INVESTOR EXPECTATIONS ON ‘RETURN’

AND ‘TRUST’ ON IPO GRADING: AN

EMPIRICAL ANALYSIS

Biju Thomas Muttath

Head–Finance (Star Group),

Research Scholar, R&D Centre,

Bharathiar University, Coimbatore–46, T.N, India

Dr. Assissi Menachery

Professor, Loyola Institute of Technology & Science,

K.K Dist, T.N, India

ABSTRACT

Oversubscription during IPO is the result of demand over supply due to

investors’ keen interest and expectation to subscribe new shares. Grading

agencies play a major role in attracting investors to subscribe shares during

IPO. This is due to the ‘trust’ that investors have on the grading agency,

regarding its capability to perform research on the key fundamental

indicators. Informed and knowledgeable investors act vigorously to get

maximum shares during the initial public offer. Book building pricing method

plays vital role in attracting the investors who anticipate efficient price

discovery. The study attempts to provide insights to investors on how

significantly efficient the listing prices of oversubscribed shares between 1 to

5 grades by approved rating agencies are; as well as the profitability in

investing oversubscribed IPOs with respect to the 1) Close price of the listing

day 2) Short term and 3) Long term returns in both manufacturing and service

sector.

Key words: Book building, Grading, Hot Issue Market, IPO, Under-pricing)

Cite this Article: Biju Thomas Muttath and Dr. Assissi Menachery, Investor

Expectations on ‘Return’ and ‘Trust’ on IPO Grading: An Empirical Analysis.

International Journal of Management, 7(3), 2016, pp. 172–184.

http://www.iaeme.com/IJM/issues.asp?JType=IJM&VType=7&IType=3

1. INTRODUCTION

Companies opt for Initial Public Offerings (IPOs) and approach potential investors for

capital, to raise funds for their various strategic plans. However, for an investor it is

questionable as to whether it makes sense to subscribe to the deluge offerings or not.

Investor Expectations on ‘Return’ and ‘Trust’ on IPO Grading: An Empirical

Analysis


Investors do not pursue value strategies because they may not be aware of the data, or

that much of evidence is refuted by the conclusions offered by the consultants [1].

Attracting and persuading the investor is the tactic of the investment banker and other

intermediaries. Investors are less informed about the fate of the issuers but glitters the

charms of the shares where insanity works among the investors [2]. In Indian IPO

market, book building mechanism was introduced in 1999 and since then gained

popularity particularly in respect of large IPOs. In this paper, researchers attempts to

study on how significantly efficient the listing prices of oversubscribed graded and

non-graded IPO’s with respect to 1) Close price of the first day 2) Short term return

and 3) Long term returns among manufacturing and service sectors.

Oversubscription of the IPO shares is the combined outcome of various

perceptions of the investors. Bull markets and irrational behavior of the investors

create a hot issue market where demand for new issues became very high [3]. In bull

market, when investors are greedy for buying stocks such IPOs, they find their way to

the hot issue market [4]. During this time, investors become irrational and their greed

to make money become prominent by investing in anything [5]. But such things

cannot happen in market especially in bull market, as the intention of issuers is to

raise maximum resources [6]. The expectations of the investors define whether the

shares are under priced or not [7]. Under-pricing of IPOs brought to the market by

reputable underwriters is lower than those brought by non reputable underwriters [8,

9]. While an IPO enhances a firm’s legitimacy, significant uncertainties remain about

its capabilities [10]. This study reveals the reality of oversubscribed IPO shares during

the period, 2006 to 2010, based on the investors’ perception on hot issue and under–

pricing phenomenon.

IPO grading is a service that provides an assessment of fundamentals regarding

quality of equity shares offered to aid comparative assessment which would be a

useful information and investment tool to investors [11]. This way, the investor, by

trusting on the IPO grading can decide whether the particular offer has potential to

bring returns or not. IPO grading methodology examines the key variables such as: i)

Business and Competitive position, ii) New projects- risks and Prospects, iii)

Financial position and Prospects, iv) Management Quality, v) Corporate governance

practices and vi) Compliance and litigation history.

ICRA and CARE have the following 5 point scale grading IPO fundamentals.

Grade 5 – Strong Fundamentals, Grade 4 – Above average Fundamentals, Grade 3

– Average Fundamentals, Grade 2 – Below average Fundamentals, Grade 1 – Poor

Fundamentals. During 1990 – 2000 many IPOs in India have vanished looting

millions of public funds. The regulator of Indian Stock Market, The Security

Exchange Board of India (SEBI) made grading of IPOs by all companies mandatory

from May 1, 2007 to help investors make informed decision and grading to be done

by the SEBI- registered crediting rating agencies. The rationale for such move, as per

SEBI, is to protect the retail investors from fly-by- night entrepreneurs. After six

years, SEBI scraped the mandatory policy of grading on December 24, 2013 making

the grading norms as voluntary.

Grading is resulting in an analysis of fundamentals and the grades should be

conveyed the same information to the uninformed investors, what the costly research

would be conveying to the institutional investors [12]. Investors incur a lower cost of

information accumulation if an IPO has some backing that signals better quality [13].

IPO grading decreases underpricing and positively influences the demand of retail

investors. In emerging markets, regulators role to signal the quality of an IPO

Biju Thomas Muttath and Dr. Assissi Menachery


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2-Jan-06 2-Jan-07 2-Jan-08 2-Jan-09 2-Jan-10

contributes towards the market welfare [11]. Studies also reveal that IPO grading has

limited influence on the IPO demand. It is not evident in Indian IPO market that IPO

pricing improves due to the introduction of IPO grading [14]. Shares which do not

have grading have higher short term return than graded [15]. Study on IPO grading on

under-pricing [16], reveals no significant influence between IPO grades and

subsequent market performance. Thus these analyses reveal the contrary results

between IPO grading and their performance. This research aims to examine the

similarities or differences among IPO grading and non-grading with respect to its

returns in manufacturing and service sectors during different investment durations.

Even though various studies on IPOs performance have been carried out in

different periods, the researchers intend to analyse the bull and bear phases of market,

IPO offerings in terms of total numbers of IPOs and influence of grading in

performance of the shares. This is because, values and IPOs are the reflections of bear

and bull markets respectively. Hence, researchers have taken up the time period that

integrate both bull and bear run to ensure homogeneity. 2006-2010 is the period both

bull and bear phases are apparent (Fig.1). Hence IPOs’ performance of these periods

had been taken into consideration to get a complete picture.

Figure 1

(NSE INDEX- NIFTY) Bull and Bear Rally during 2006 – 2010

Bear Rally-1

Bull Rally-1 Bull Rally-2

Moreover, special focus on manufacturing and service sectors with respect to IPO

performance in these periods has given preference in the present study. Other studies

with comparative analysis on manufacturing and service sector found to be scarce.

Hence, comparative analysis of the manufacturing and service sectors on the:

1. Listing day(first day) return

2. Short term return, and

3. Long term return would give insight to the investors regarding the right time for

investment in hot issue shares.

2. OBJECTIVES OF THE STUDY

1. To analyze and study the returns obtained while investing in graded IPOs on various

time periods such as a) First day of trade b) Short term basis and c) Long term basis

2. To analyze and study the returns obtained while investing in graded IPOs belonging

to manufacturing sector on various time periods such as a) First day of trade b) Short

term basis and c) Long term basis


Analysis


3. To analyze and study the returns obtained while investing in graded IPOs belonging

to service sector on various time periods such as a) First day of trade b) Short term

basis and c) Long term basis.

4. To analyze and study the returns obtained while investing in hot issue shares

(oversubscribed IPOs) on various time periods such as a) First day of trade b) Short

term basis and c) Long term basis.


(oversubscribed IPOs) belonging to manufacturing sector on various time periods

such as a) First day of trade, b) Short term basis and c) Long term basis.


(oversubscribed IPOs) belonging to service sector on various time periods such as a)

First day of trade b) Short term basis and c) Long term basis.

2.1. Hypotheses

1. There is no significant relationship between the average rates of returns obtained

while investing in hot issue shares (oversubscribed IPOs) and the time periods such as

a) First day of trade b) Short term and c) Long term.


while investing in hot issue shares (oversubscribed IPOs) in manufacturing sector and

the time periods such as a) First day of trade b) Short term and c) Long term.


while investing in hot issue shares (oversubscribed IPOs) in service sector and the

time periods such as a) First day of trade b) Short term and c) Long term.


while investing in hot issue shares (oversubscribed IPOs) and the time periods such as

a) First day of trade b) Short term and c) Long term.


while investing in hot issue shares (over subscribed) in manufacturing sector and the

time periods such as a) First day of trade b) Short term and c) Long term.


while investing in hot issue shares (over subscribed) in service sector and the time

periods such as a) First day of trade, b) Short term and c) Long term.

2.2. Methodology

2.2.1. Sample

Sample containing 220 from 321 companies came out with IPO, during the period

2006- 2010 have been considered in the study (Table 1). Out of 220 companies 94

were graded by registered agencies (Table 2). The information is drawn from the

SEBI, NSE and ICRA.

Table 1

Year wise IPOs & Sampling Frame

Year 2006 2007 2008 2009 2010 Total

Number

of IPO’s

Population 91 107 38 21 64 321

Sample 70 69 18 14 49 220



Table 2

Grading – Sector Wise

Sector

Grades

Total High (4 and 5) Medium (3) Low (1 and 2)

Service 18 28 14 60

Manufacturing 7 13 14 34

Total 25 41 28 94

2.2.2. Sampling frame and Characteristics

It has been observed that all shares were oversubscribed by investors. The sample

consists of 220 companies are drawn on the criteria of availability of information on

IPO regarding book building price, issue date, issue price, listing date, listing day,

close price, short term price and long term price.

‘Book building price’, ‘Return on first day’, ‘Short term return’ and ‘Long term

return’ have been considered for the analysis.

Return on first day is the return on the closing hours of the listing day.

Short term return is considered as the return after the first year of listing and

Long term return is considered as return on 30th October 2015. Long term is

considered as more than five years.

These returns are again classified as positive and negative returns. The shares

have categorized into two sectors such as manufacturing and service. The graded

shares are grouped into three categories such as ‘High’, ‘Medium’ and ‘Low’. Shares

with 4 and 5 grades are categorized as high grade, shares with ‘3’ grade are

categorized as medium grade and shares with 1 and 2 grades are categorized as low

grade.

2.2.3. Technique

Cross sectional analysis is carried out to explore the significance or difference with

respect to returns generated in various time periods. Data collected were analyzed

using various statistical tools and the results are presented. Null hypotheses

formulated for the purpose of present investigation are put together using inferential

statistical tools. Chi-Square test is used to find out the significant association between

sectors, grading and returns. During discussion, attention has to been given in arriving

at a conclusive perspective on the analysis, hypotheses testing and interpretation of

data related to the variables. The results are discussed in detail.

2.3. Analysis Results and Discussion

2.3.1. Analysis: Grading and Listing day return

It is clear from the Table 3 that out of the total 94 shares that have been graded, 37

(39.4%) shares have given negative return and 57 (60.6%) shares have given positive

return. While considering the shares that have graded high, out of 25 shares, 4 (16%)

shares have given negative return and 21 (84%) shares have given positive returns.

Among the shares that have been graded as medium, out of 41 shares, 19 (46.3%)

shares have given negative return and 22 (53.7%) shares gave positive returns. When

low graded shares are considered, out of 28 shares 14 (50%) shares gave negative

return and 14 (50%) shares have given positive returns on first day of listing.


Analysis


Table 3

Grading and Listing day return

Classification of

Grading

Return

Total Negative Positive

High 4 (16%) 21 (84%) 25(100%)

Medium 19 (46.3%) 22 (53.7%) 41(100%)

Low 14 (50%) 14 (50%) 28(100%)

Total 37 (39.4%) 57 (60.6%) 94(100%)

From Table 4 it is observed that the grading influences listing day returns whether

positive or negative. Further, the results of Chi-square provide the first indication that

the hypotheses is not supported, grading has an influence on listing day returns

whether positive or negative. Hence we reject the null hypotheses that there is

significant relationship between grading and listing day returns (positive or negative).

It is inferred from table 4 that there is relationship between grading and listing day

returns.

Table 4

Chi Square – Listing day return

Value df Asymp. Sig. (2-sided)

Pearson Chi-Square 7.881 2 .019

Likelihood Ratio 8.606 2 .014

Linear-by-Linear As 6.094 1 .014

N of Valid Cases 94

**Significant at 0.05 significance level

It is found that 60.6% of the graded IPOs have provided positive return on the

listing day. Among this, while considering higher grades 84% has provided positive

return on the listing day, whereas in medium grade 53.7% have got positive return and

in low grade 50% have got positive return. From this it can be concluded that

investing in higher graded IPO’s are advisable, provided the shares are sold on the

first day of the listing. Another possibility is that to short sell such shares on the

listing day. The study supports the findings of previous studies [2,17,18,19] where

they establish the presence of underpricing during the initial book building process

and creating artificial demand for retail investors during the initial hike of share price

on the first day. This is reported to be the advantage of information edge, which

financial institutions have over retail investors.

2.3.2. Analysis and Discussion: Grading and Short term return

It is clear from Table 5 that among the total 94 shares that have been graded, 74


return. While considering the shares that have graded high, among the 25 shares, 18

(72%) shares have given negative return and 7 (28%) shares gave positive returns. In

the category of medium graded shares, among the 41 shares, 30 (73.2%) shares have

given negative return and 11(26.8%) shares gave positive returns. Where as in low

graded shares out of 28 shares 26 (92.9%) shares have given negative return and 2

(7.1%) shares gave positive returns in short term.



Table 5

Grading and Short term return

Classification of

Grading

Return


High 18 (72%) 7 (28%) 25 (100%)

Medium 30 (73.2%) 11(23.8%) 41 (100%)

Low 26 (92.9%) 2 (7.1%) 28 (100%)

Total 74 (78.7%) 20(21.3%) 94 (100%)

From Table 6 it is observed that grading does not influence short term returns

whether positive or negative. Further the results of Chi-square provide the first

indication that the hypotheses should support grading of IPO’s does not have any

relationship at 0.05 confidence level on short term returns whether positive or

negative. However it shows statistically significant at 0.01 confidence level. Hence

we accept the null hypotheses that there is no significant relationship between grading

and short term returns (positive or negative) at 0.05 confidence level. It is inferred

from the above table that there is no relationship between grading and short term

returns (positive or negative).

Table 6 Chi Square – Short term return

Value Df Asymp. Sig. (2-sided)




N of Valid Cases 94

*Not Significant at 0.05 and 0.01 significance level

It is clear from the Table 7 that out of the total 94 shares that have been graded, 70


return. While considering the shares that have graded high, out of 25 shares 16 (64%)

shares have given negative return and 9 (36%) shares have given positive returns. In

medium grade category, out of 41 shares 31 (75.6%) shares have given negative

return and 10 (24.4%) shares have given positive returns. Where as in low graded

shares out of 28 shares 23 (82.1%) shares have given negative return and 5(17.9%)

shares have given positive returns in long term.

Table 7

Grading and Long term return

Classification of

Grading

Return


High 16(64%) 9 (36%) 25(100%)

Medium 31(75.6%) 10(24.4%) 41(100%)

Low 23(82.1%) 5(17.9%) 28(100%)

Total 70(74.5%) 24(25.5%) 94(100%)


Analysis


From the Table 8 (Appendix) it is observed that the grading does not influence

long return whether positive or negative. Further the results of Chi-square provide the

first indication that our hypotheses should support that grading of IPOs does not have

any relationship on long term returns whether positive or negative. Hence we accept

the null hypotheses that there is no relationship between grading and long term

returns.

Table 8

Chi Square – Long term return

Value Df Asymp.

Sig. (2-sided)




No of Valid Cases 94


2.3.3. Analysis and Discussion: Manufacturing and Service Sector

It is clear from the Table 9 that among the total sample of 220 shares, 77 (35%) shares

have given negative return and 143 (65 %) shares gave positive return. While

considering the shares belong to service sector, among the 133 shares, 46 (34.6%)

shares have given negative return and 87 (65.4%) shares have given positive returns.

In manufacturing sector, among the 87 shares, 31 (35.6%) shares have given negative

return and 56 (64.4%) shares have given positive returns on the listing day. It can be

inferred that on listing day most of the shares generate positive return.

Table 9

Sectors and Listing day Return

Sectors Return


Service 46 (34.6%) 87(65.4%) 133(100%)

Manufacturing 31 (35.6%) 56 (64.4%) 87 (100%)

Total 77 (35%) 143 (65 %) 220 (100%)

It is clear from Table 10 that the sectors do not influence listing day returns


indication that our hypotheses should be supported that sectors does not have an

influence on listing day returns whether positive or negative. Hence we accept the null

hypotheses that, there is no significant relationship between manufacturing and

service sectors and the listing day return (positive or negative).



Table 10

Chi Square – Listing day

Value Df Asymp.Sig.

(2-sided)

Exact Sig

(2 sided)

Exact Sig (1

sided)

PearsonChi-Square .025 1 .874

Continuity correction .000 1 .988

Likelihood Ratio .025 1 .874

Fisher’s Exact Test .886 .493

Linear-by-Linear As .025 1 .874

N of Valid Cases 220


It is also clear from the study that among the total 220 oversubscribed IPO’s

belonging to service and manufacturing sectors, 65% of the total shares generated

positive return on listing day. Among this, while considering the service sector, 65.4%

has provided positive return and 64.4% of manufacturing sector provided positive

return on the listing day. It can be inferred from the analysis that both service and

manufacturing sectors are indifferent in providing return on listing day in between 64

to 66%. The study supports the findings of various studies [11,16,18,20,21] on the

underperformance of IPOs in Indian and foreign stock markets and substantiate the

prevalent under pricing phenomena.

It is clear from the Table 11 that among the total sample of 220 shares,

151(68.6%) shares have given negative return and 69 (31.4%) shares have given

positive return. While considering the shares belonging to service sector, among the

133 shares 94 (70.7%) shares have given negative return and 39 (29.3%) shares have

given positive returns. In manufacturing sector, among the 87 shares, 57 (65.5%)

shares have given negative return and 30 (34.5%) shares gave positive returns in short

term.

Table 11

Sectors and Short Term Return

Sectors Return


Service 94 (70.7%) 39 (29.3%) 133(100%)

Manufacturing 57 (65.5%) 30 (34.5%) 87 (100%)

Total 151(68.6%) 69 (31.4%) 220 (100%)

It is clear from Table 12 that the sectors does not influence short term returns


indication that our hypotheses should support that sectors do not have any influence

on short term whether positive or negative. Hence we accept the null hypotheses that

there is no significant relationship between manufacturing and service sectors and

short term returns (positive or negative).


Analysis


Table 12

Chi Square – Short term return

Value Df Asymp. Sig.

(2-sided)

Exact Sig

(2 sided)

Exact Sig (1

sided)

Pearson Chi-Square .650 1 .420






It is clear from the Table 13 that among the total sample of 220 shares, 162

(73.6%) shares have given negative return and 58 (26.4 %) shares have given positive

return. While considering the shares which belong to service sector, out of 133 shares,

99 (74.4%) shares have given negative return and 34 (25.6%) shares have given

positive returns. In manufacturing sector, among the 87 shares, 63 (72.4%) shares

have given negative return and 24 (27.6%) shares gave positive returns in the long

term.

Table 13

Sectors and Long Term Return

Sectors Return Total

Negative Positive

Service 99 (74.4%) 34 (25.6%) 133(100%)

Manufacturing 63 (72.4%) 24 (27.6%) 87 (100%)

Total 162 (73.6%) 58 (26.4 %) 220 (100%)

From Table 14 (Appendix), it is observed that the sectors do not influence long

term returns whether positive or negative. Further the results of Chi-square provide

the first indication that our hypotheses should support that sectors do not have any

influence on long term whether positive or negative. Hence we accept the null

hypotheses that there is no significant relationship between manufacturing and service

sectors and long term returns (positive or negative).

Table 14

Chi Square – Long term return

Value df Asymp.

Sig.(2-sided)

Exact Sig

(2 sided)

Exact Sig

(1 sided)

Pearson Chi-Square .111 1 .739








2.4. Discussion

The study intends to find out the relevance of IPO grading on the day of listing, as

well as on short term and long term returns. Moreover, the study also brings out the

relevance of investing in oversubscribed IPO’s on listing day, short term and long

term time periods.

From the study it is revealed that grading is not an indicator to get profits on short

term and long term basis. Only 20.3% and 25.5% of graded shares generated positive

return in short term and long term respectively. It is also clear from the study that total

of 220 overs subscribed IPO’s belong to service and manufacturing sectors has not

performing as expected by the investors in short term and long term periods. The

study also reveals that shares of medium grade is generating more profit in all three

periods, this supports the previous study [22]. The study recommends the investors to

invest in service sectors with high grade in order to generate positive return on listing

day of the IPOs. In spite of the information asymmetry prevailing in the stock market,

retail investors are consciously burning their fingers. Credit rating and grading are the

supportive indicators that can be considered for investing but not for a trusted value

investing. Probably, focusing on these persistent hot issues and underpricing

phenomena, the regulator took lenient step on the mandatory grading.

In order to generate return from investment, individuals ought to look into two

important qualitative aspects viz, quality of the management and sustainability of the

business in the present and future economic scenario. Risk analysis is another

important tool by which companies ensure sustainability in future so that investors

will be in a position to gain return from the investment. Negative returns in short term

and long term periods are evident in the stock market which emphasizes under

valuation of shares in the book building process. Moreover it becomes a relevant

question that whether companies are conducting adequate risk analysis that involves,

risk identification, assessment and mitigation. It is an alarming situation to note that

among the total 321 oversubscribed IPOs, only 20.3% and 25.5% of graded shares

generated positive return in short term and long term respectively. This calls for

immediate action from the SEBI, RBI and relevant statutory and regulatory authorities

to take appropriate corrective actions to bring out the governance of Indian companies

back into action.

Summary

1. There is a significant relationship between grading and listing day returns (positive or

negative) at 0.05 significant level.

2. There is no significant relationship between grading and short term returns (positive

or negative).

3. There is no significant relationship between grading and long term returns (positive

or negative).

4. There is no significant relationship between Manufacturing and Service sectors and

listing day returns (positive or negative).

5. There is no significant relationship between manufacturing and service sectors and

short term returns (positive or negative).

6. There is no significant relationship between manufacturing and service sectors and

long term returns (positive or negative)


Analysis


3. FUTURE RESEARCH DIRECTIONS

Initial Public Offerings are characterized by phenomena such as hot issue market,

under pricing and long term under performance. Researchers considered grading,

oversubscribed IPO’s and sectors as the variables to explore its influence on return of

IPO shares on listing day, shot term and long term returns. Investor heuristic,

economic indicators, political, national and international scenarios are few of the

other factors which determining the bull and bear rally in the stock market. Influence

of these factors on IPO prices, grading and its return at different time periods can also

be considered for detailed analysis to explore the philosophy of IPO returns.

4. CONCLUSION & RECOMMENDATIONS

The main reason behind companies’ decision to go public is to raise money and

spread the risk of ownership among a large group of shareholders. Reducing debt

component in the source fund is another major motive behind IPOs. While going for

investing in IPO, informed investors are rich with the information on fundamental

aspects of the issuing company. In order to reduce the impact of information

asymmetric, SEBI introduced grading mechanism. The Cross tabulation, Chi square

and Correlation study reveals that grading is not an indicator to get profits on short

term and long term basis. Only 20.3% and 25.5% of graded shares generated positive

return in short term and long term respectively. However it is found that 60.6% of the

graded IPOs have provided positive return on the listing day. Among this, while

considering higher grades 84% has provided positive return on the listing day,

whereas in medium grade 53.7% has got positive return and in low grade 50% has got

positive return. From this it can be concluded that investing in higher graded IPO is

advisable, provided the shares are sold on the first day of the listing. Further the study

emphasis the pervasiveness of under-pricing phenomena in book building process of

Indian IPO market. We strongly advocate that an investor goes for an IPO offer will

be in a position to generate a positive return, if he/ she off load the shares on the first

day of listing. The role of grading agencies in awarding various grades is also

questionable as the strips graded 3, 4 and 5 failed to meet the expectations of the

investors. Trust on grading agencies in awarding 4 and 5 graded shares are also

skeptical. We conclude that IPO is a speculation opportunity to make expected return

on listing day and grading is not the only parameter investors should rely upon.

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