1. Literature review and HypothesesdevelopmentLiteratures use the terms first-day returns andunderpricing interchangeably. The first day return or the initial return ismeasured using the closing price of the first day. Studies show that there is asystematic increase from the IPO’s offer price to the first day closing price.Ritter et al.
(2002) shows that in a sample of 6,249 IPOs from 1980 to 2001 theaverage first-day return is 18.8 percent, and proximately 70 percent of theIPOs finish the first day of trading at a closing price greater than the offerprice. The average IPO underpricing, 18.8 present, is unlikely to be a resultof misevaluation or asset-pricing risk premia because of the magnitude of theunderpricing and the inability to explain why the second-day investorspurchasing from first-day investors do not require this premium. Usually,fundamental risks or constraints are not resolved within one day. Clearly, Thedifference in the perceived value of equity between the issuer and theinvestors results in IPO underpricing. This perception is subjected to variousendogenous and exogenous factors working to mitigate or emphasize theunderpricing.
They state “no exceptionsto the rule that the IPOs of operating companies are underpriced, on average,in all countries.”Asymmetric Information and signaling theory state that whenthe investors have less information, they fear a lemon problem, that only lowquality issuers are the one who initiates the IPO. As a signal of high qualityand to distinguish themselves from the lemons, the high quality issuers intentionallyunderprice their shares, which deter lower quality issuers from imitating. Therefore,based on the model, degree of underpricing is positively correlated with thefirm quality. This money that was left on the table defined as the number ofshares sold times the difference between the first day closing price and theoffer price leaves a good taste in investors mouth and can thus be exploited asan increase in in the demand on the seasoned equity offering (Welch, 1989), responsesto future dividend announcements (Allen and Faulhaber, 1989) and analystcoverage (Chemmanur, 1993). Therefore,the expected benefit derives from the post IPO’s activities (e.
g., SEO) exceedsthe signaling marginal cost. However, although (Welch, 1989) claim that an explanation ofthe IPO underpricing is the signaling theory, providing evidence of thesubstantial post-issuing market activity by IPO firms, there is a reason tobelieve that price appreciation would induce issuers firms to return to themarket for more equity funding as (Ritter, 2002) states. In fact, (Jegadeesh,Weinstein, and Welch, 1993) state that under the signaling theory issuers are(a) Firms with higher IPO returns are likely to issue larger amount of seasonedequity than firms with lower IPO returns. (b) Likely to issue larger amounts ofequity in their seasoned offerings; (c) likely to issue seasoned equity morequickly after the IPO; and (d) likely to experience a smaller price drop whenthe SEO is announced. Also, (Beatty and Ritter, 1986) demonstrate that there is apositive relation between the IPO underpricing and the uncertainty of investorsregarding its value. As the uncertainty regarding the issue increases, investorswill demand that more money be ‘left on the table’ and thus more underpricing.
When the investors have more information about the generalmarket demand for shares, the issuers face an allocation problem. (Rock, 1986) model assumes that investors aredifferentially informed, obtaining information is expensive for the investors, andthus higher pricing leads to a winner’s curse among uninformed investors. Theissuer is interested in attracting both classes of investors to make the issuesuccessful because full subscription is related to the level of participationby uninformed investors. Also, uninformed investors are perceived as strategicinvestors and investment by them is normally targeted for a longer period. Also, a related issue to the investors having moreinformation about the demand is the informational cascade theory (welch, 1992).The theory assumes that sequential IPO shares selling leads potential investorsto learn from the purchasing decisions of earlier investor.
This createsherding effect due to dynamic information and investors completely ignore theinformation obtained by them. Demand canbe so elastic and the offerings succeed or fail rapidly based on the pricing.Pricing just a little too high indicates a high probability of complete failurebecause the later investors abstain based on the first investors abstinence.Therefore, an issuer may underprice in order to guarantee the offering tosucceed and may want to reduce the communication among investors by spreadingthe selling effort over a more segmented market. The process of bookbuildingmight mitigate the underpricing issue since it allows underwriters to obtaininformation from informed investors and set the price accordingly. Bookbuilding works as a reduction of the variance in the magnitude of informationasymmetry between various classes of investor by allowing flexible bids byprospective investors within a predetermined price range.
However, (Ritter, 2002) states non-rationaland agency conflict explanations offer considerable promise of explaining theunderpricing.Firms’ visibility in emerging markets is morepronounced because the majority of traders are individual traders, which givesus the opportunity to test the effect of individual recognition and firm’s visibilityon trading behavior. Therefore, emergingmarkets can serve as laboratories for studying the relationship between marketirrationality and underpricing issue. Investor Recognition and IPOUnderpricing: Physical, legal, and informationobstructions can impede capital flows and lead to segmented inefficient globalfinancial markets.
Advances in technology and regulatory reforms have reducedmany of these barriers to trade; however, philosophical, cultural, andreligious differences might produce barriers to trade and investigating themmight provide significant new economic insights. Emerging markets might serve as laboratories for studyingthe relationship between market barriers, financial market integration, andeconomic efficiency. Particularly, the Islamic emerging financial marketsrepresent a unique opportunity to observe the impact that cultural differences,in the form of religious investment restrictions, can have on the efficiency ofthe underlying financial markets.Prior studies show recognition by investors can be affectedby media coverage (Fang and Peress, 2009), firm geographic location (Loughranand Schultz, 2005), initiation of analyst coverage (Irvine, 2003), hiring ofinvestor relations firms (Bushee and Miller, 2012), and increases inadvertising expenditures (Grullon, Kanatas, and Weston, 2004). (Asem et. al,2016) show that Sharia stock classification affect firm’s recognition by equitymarket’s participants. They link investor recognition to stock liquidity byshowing that Sharia stock classification acts as a source of informationdissemination to outside investors.
Islamic scholars provide important informationto potential investors by screening firms in order to classify them as Islamicor conventional. Depending on each investor’s adherence to their beliefs,Islamic investors typically refrain from firms that are not Islamic(conventional stocks) and will only demand Islamic firms. In contrast,conventional investors will demand firms’ stocks regardless of their classification.Therefore, a wider base of both Islamic and conventional investors in SaudiArabia will demand Islamic firms’ stocks, while conventional firms’ stocks willbe demanded only by narrower base of investors.Moreover, in asset pricing field, the idea that”neglected” stocks earn a return premium over “recognized” stocks has been inexistence for many years (e.g.
, Arbel et al., 1983). Therefore, since Islamicstocks are traded by both Islamic and conventional investors and have broaderclientele and, thus, have higher media and analyst coverage, which leads to ahigher degree of investor recognition. In Merton’s (1987) framework, firmidiosyncratic risk is priced because of the imperfect diversification thatstems from a lack of investor recognition. Firms with higher idiosyncraticvolatility should offer a return premium to compensate shareholders for theundiversified risk they impose.
Therefore, conventional firms have higheridiosyncratic risk since they are not traded by all the market participants andthis risk should be compensated. (Asem et. al, 2017) show that Islamic stockshave lower idiosyncratic volatility, indicating that Islamic stocks are held bybroader investor base than conventional stocks. The same argument can be statedregarding the IPO underpricing; since conventional firms have higheridiosyncratic risk because their stocks cannot be traded by all the marketparticipants and this risk should be compensated, this compensation might comesas in increase in the initial return (more underpricing). Moreover, since conventional stocks cannot betraded by all the market participants and have less recognition, theuncertainty of investors regarding its value would increase and thusintensifies the underpricing. (Beatty and Ritter, 1986) demonstrate that thereis a positive relation between the IPO underpricing and the uncertainty ofinvestors regarding its value because as the ex ante uncertainty regarding theissue, making the winner’s curse problem intensifies. A classification based on religious restrictionscreates market segmentation and has a great effect on IPO offer price andsubscription. In fact, this classification actively promotes Islamic firms andmakes them recognized by a greater number of investors than conventionalstocks.
Therefore,the classification is a way of promotion. (Habib and Ljungqvist , 2001) arguethat firms’ owners affect the level of underpricing through the choices theymake in promoting an issue, such as marketing expenditure. Therefore, there isa trade-offs between promotion costs of going public and underpricing. Atestable implication of this model is that marketing expenditure increases withthe offering size and decreases underpricing. Therefore, I hypothesize that Islamic firmsbeing more recognized by investors would have less IPO underpricing relative toconventional firms.Illiquidity: (Ellul, Pagano, 2006) show that the less liquid theaftermarket is expected to be, and the less predictable its liquidity, thelarger will be the IPO underpricing. They theorize a model that blendsliquidity concerns with adverse selection and risk and as motives forunderpricing.
Using several measures of liquidity, they find that expectedafter-market liquidity and liquidity risk are important determinants of IPOunderpricing. It is well documented the relationship between returns andliquidity with reference to seasoned securities. (Amihud and Mendelson, 1986)among the first who argue that illiquid securities provide investors with ahigher expected return to compensate them for the larger trading costs theyhave to bear.
The argumentof SEO should be also applicable on the IPO offering. If liquidity is priced on second market, itis reasonable to expect stocks on the primary market to price liquidity. Infact, the liquidity concern is more pronounced in the primary market and shouldbe priced more since it is a source ofuncertainty more than for seasoned securities. In fact, IPO investors donot know yet how liquid the aftermarket will be and therefore will want to becompensated also for this uncertainty. Therefore, I hypnotize that Investor Recognition iscorrelated with liquidity.
Because Islamic firms are more recognizable amonginvestors, the liquidity risk factor is going to be reflected on the pricing asa decrease in the return. On the other hand, investors knowing thatconventional firms are less recognizable and thus have a higher after-marketilliquidity would demand more ‘money be left on the table’ as a compensation ofthe illiquidity risk. Therefore, I expect a positive correlation between IPOunderpricing and illiquidity. Also, I expect that conventional firms are onaverage associated with higher after-market illiquidity. 2. Data:Reasons to choose Saudi market: I choose the stock market of Saudi Arabia totest the effect of visibility on IPO pricing for several reasons.
First, themajority of traders in the Saudi stock market are individual traders, whichgives us the opportunity to test the effect of individual recognition ontrading behavior. Secondly, Saudi Arabia has a majority Muslim population, andit is known for its strong adherence to Sharia law, which gives us theopportunity to test the effect of religious beliefs on investor investmentdecisions and portfolio construction. Third, in Saudi Arabia, clerics andIslamic finance scholars voluntarily screen stocks and financial instrumentsfor their Sharia compliance and attempt to disseminate this information to thepublic through different media channels. Therefore, using the sample of Saudistocks makes it possible to examine the impact of visibility on IPO pricingproxied by Islamic-compliance firms.As a proxy for investors’ recognition, I usethe classification list for Islamic or conventional firms published by Shariascholars. These classifications differ in the screening process and criteriafor selecting Islamic firms, but share some criteria, like the prohibition ofcertain activities, such as (1)activities that involve in any form of usury or interest rates.
(2) Activitiesthat involve excessive risk, uncertainty, ambiguity, or deception. (3)Activities that are related by any means to gambling, lottery, or game ofchance. (4) Activities that are related to non-halal businesses, such as thosethat deal with pork, adult entertainment, tobacco, non- medical alcohol, andall other unethical businesses.
In this paper, I rely on Dr. Al-Fozan’s stockclassification reports since it is commonly used by investors, covers stockslisted in all sectors of equity market, and it is one of the strictestclassification as a base classification. My sample consists of all firm-commitmentinitial public offering from 2004 to 2017 in Saudi Arabia as reported byTadawel. I also obtain a complete list of IPO prospectus, which I use to getthe offering announcement dates, offering price, size of issue, and size offirms.
I also obtain the first day closing price for each firm using Tadaweldatabase. The sample consists of 110 observations. Before examining the IPO underpricing of conventionaland Islamic stocks, I analyze the differences in IPO offering characteristicsbetween the two classes.
Table 1 shows the summary statistics of firms duringthe sample period, which spans from Jan 2004 to Dec 2017. Separating firms intotwo groups, Islamic and conventional firms, based on Al-Fozan’s stockclassification shows that conventional firms tend to have a bigger firm size thanIslamic firms since the mean firm size of conventional firms is higher thanthat of Islamic firms. However, Islamic firms have a higher offer size than theconventional firms.
There is no distinguishable difference in means between thetwo classes.