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Underpricing new issues on the London Stock Market: how modern day IPOs compare with the past

Ford Motor was the Google of the 1920s. In November 1928, Ford, the US parent, listed the shares of its British subsidiary on the London Stock Exchange and the share price rose a massive 86 per cent on its first day of trading. This compares with a rise of only 18 per cent in the case of Google's initial public offering (IPO) on NASDAQ in August 2004.

The Ford-Google comparison accords with our intuition that there should have been greater IPO underpricing the further back we go in time. But on the contrary, according to new research by David Chambers, while underpricing from 1959 up to the present has averaged around 17 per cent, the average before that - between the end of World War I and 1959 - was less than 8 per cent.

While investors lucky enough to receive shares in IPOs like Ford and Google are delighted with the initial returns, the issuing firms should be less pleased having failed to maximise the proceeds raised and having 'left money on the table'. This phenomenon is called 'underpricing'. Underpricing is one yardstick of the stock market's efficiency, which allows us to look at how good a job the market has done over time.

While we know a lot about underpricing over the period since the 1960s in the United States and Britain, until now, nothing was known about what happened before then. Given that prior to 1945, the stock market was only lightly regulated, the involvement of the most reputable merchant banks minimal and corporate disclosure was poor, we might expect to see greater underpricing earlier in the last century.

Chambers' research, which he presented at the Economic History Society's Annual Conference on Friday 8 April, contributes to our knowledge about the long-run behaviour of stock markets by assembling a new data set on British IPOs and analysing the change in IPO underpricing over time.

Britain was the second most important stock market in the world in terms of relative size in the early 20th century surpassed only by the United States. The analysis includes almost 2,300 IPOs of ordinary shares on the London market between 1915 and 1990.

Prior to 1915, it is not possible to find recorded share prices of new entrants to the market despite there being plenty of IPOs. The end year of 1990 marks a significant change in issue method from the fixed price offer method that characterised IPOs for most of the last century to a book building approach, which introduced more flexibility into the IPO process and in theory should encourage lower underpricing.

Contrary to the researcher's prior expectation and despite improvements in regulation by the London Stock Exchange, prospectus disclosure by issuing firms and participation by reputable merchant banks along with better investor protection, underpricing rises in the second half of the century compared with the interwar years.

This rise cannot be explained by any composition effect in the IPO sample, that is, by changes in the riskiness of firms or other characteristics of IPOs across time.

Plausible explanations for this puzzle involve such changes in the institutional environment surrounding IPOs in the second half of the 20th century as the increasing power of the sponsoring merchant banks over issuing firms, the decline of competition for IPO business from the provincial stock exchanges as they moved towards a merger with London in 1973, and the exacerbation of a 'winner's curse' problem in IPOs as institutional investors became more dominant.

Improvements in regulation, disclosure and the involvement of reputable merchant banks in the second half of the last century did not have the desired effect as far as underpricing was concerned.

But before concluding that the interwar London stock market did a better job in meeting the objectives of issuing firms and that any subsequent efforts to improve the IPO process were ineffective, we need to take a closer look at the longer-term survival and performance of IPOs.

Here, the initial evidence from IPOs in the late 1920s in particular is that performance was substantially worse than that seen by the dotcom IPOs of the late 1990s.




How Well Did the Stock Market Treat Industry? Evidence from Initial Public Offerings on the London Stock Exchange over the 20th Century by David Chambers was presented at the Economic History Society's 2005 Annual Conference at the University of Leicester on Friday 8 April.

David Chambers is a postgraduate student in the Economic History department at the London School of Economics and Political Science.

11 April 2005