DOES IPO GRADING POSITIVELY INFLUENCE RETAIL INVESTORS? A QUANTITATIVE STUDY IN INDIAN CAPITAL MARKET

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1 DOES IPO GRADING POSITIVELY INFLUENCE RETAIL INVESTORS? A QUANTITATIVE STUDY IN INDIAN CAPITAL MARKET Abstract S.Saravanan, Research Scholar, Sathyabama University, Chennai Dr.R.Satish, Associate Professor, SRR Engineering College, Padur 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 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 61

2 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. 62

3 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 63

4 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 64

5 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

6 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 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 Asymp. Sig. (2- Value Df sided) Pearson Chi-Square Likelihood Ratio Linear-by-Linear Association

7 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 relationship is identified to be moderate(table 3) Symmetric Measures Asymp. Std. Value Error(a) Approx. T(b) Approx. Sig. Nominal by Nominal Phi Cramer's V Contingency Coefficient Interval by Interval Pearson's R Ordinal by Ordinal Spearman Correlation N of Valid Cases 140 Table 3 Strength of relationship between IPO grading and Listing day returns 67

8 Chart 1- IPO Grading Vs Listing Day Returns Credit rating Vs Retail Investors Interest Subscription Rating >100% <100% 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 68

9 Chi-Square Tests Value df Asymp. Sig. (2- sided) Pearson Chi-Square Likelihood Ratio Linear-by-Linear Association N of Valid Cases 140 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 To analyse how strong the relationship is tested with cramer s rule. From the available value of relationship is identified to be very low Symmetric Measures Asymp. Value Std. Error(a) Approx. T(b) Approx. Sig. Nominal by Nominal Phi Cramer's V Contingency Coefficient Interval by Interval Pearson's R Ordinal by Ordinal Spearman Correlation N of Valid Cases

10 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 Loss 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 70

11 Chi-Square Tests 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 To analyse how strong the relationship is tested with cramer s rule. From the available value of relationship is identified to be moderate Symmetric Measures Value df Asymp. Sig. (2- sided) Pearson Chi-Square E-05 Likelihood Ratio E-06 Linear-by-Linear Association N of Valid Cases 140 Table 8: Chi square for Listing day return vs retail investor s interest Asymp. Value Std. Error(a) Approx. T(b) Approx. Sig. Nominal by E- Nominal Phi Cramer's V E- 05 Contingency Coefficient E- 05 Interval by Interval Pearson's R Spearman Correlation Ordinal by Ordinal N of Valid Cases

12 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, Chemmanur, T. J., Hu, G. and Huang, J. K. (2010)'The Role of Institutional Investors 72

13 in Initial Public Offerings', Review of Financial Studies, 23(12), 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): Loughran. T., Ritter. J.,2002. Why don't issuers get upset about leaving money on the table in IPOs? Review of Financial Studies 15, Rajan, R. G. (1992) 'Insiders and outsiders: The choice between informed and arm's length debt', Journal of finance, Ritter, J. R. (1984)'The" hot issue" market of 1980', Journal of Business, Ritter, J. R. (1987)'The costs of going public', Journal of Financial Economics, 19(2),