IPOs biotechnology

evidence on the aftermarket performance of Initial Public Offerings (IPOs) in Sri Lanka, focusing on 144 firms listed on the Colombo Stock Exchange (CSE) between 1991 and 2017. The CSE, a relatively small but significant market in the context of Sri Lanka’s financial system, has grown considerably over the years, especially following political reforms in 2009. This study spans nearly three decades and offers new insights into how IPOs perform over time in an emerging market, addressing a key gap in the literature where much of the focus has traditionally been on developed markets. By examining long-term returns and market-adjusted performance, the study provides a granular look at how IPOs behave in the aftermarket, offering valuable lessons for investors and firms alike.

The research reveals that short-term returns for IPOs on the CSE are generally low, averaging under 1% in the first few months after listing. However, this picture changes significantly over time. Long-term returns, measured through buy-and-hold abnormal returns (BHRs), gradually improve, peaking at an average of 12.46% over a three-year period. This finding suggests that the CSE, like many emerging markets, offers rewards for patient investors who are willing to hold IPO shares over the long term. Importantly, this trend supports the divergence of opinion hypothesis, which posits that initial investor optimism, often inflated due to limited information and high expectations, fades over time as more information becomes available, leading to more stable and realistic market performance.

Investor sentiment and the volume of IPO listings also play a significant role in shaping aftermarket performance. The study finds a positive correlation between high investor sentiment and better IPO performance, particularly in the long run. Similarly, a higher volume of IPO listings is associated with stronger returns, suggesting that investor confidence in the market as a whole tends to buoy individual IPO performances. Conversely, initial underpricing, which is common in IPOs as firms and underwriters attempt to generate interest, tends to have a negative impact on long-term returns. This indicates that while underpricing can create a short-term buzz, it often results in market corrections that lower long-term profitability.

The divergence of opinion hypothesis is central to the study’s findings. This hypothesis suggests that early IPO investors are often overly optimistic about a stock’s potential, leading to overvaluation on the listing day. As more information about the stock becomes available over time, these optimistic projections adjust downward, leading to lower returns in the short term. The study uses short-term volatility as a proxy for measuring this divergence of opinion, finding a clear negative relationship between early volatility and long-term returns. In simpler terms, the more volatile the stock in its early days, the worse it performs over the long run, as initial over-optimism is replaced by more tempered market evaluations.

Another important theoretical perspective explored in the paper is the impresario hypothesis. This theory suggests that investment banks and underwriters often manipulate the IPO process by deliberately underpricing shares to create the illusion of excess demand. This initial underpricing generates strong early returns as investors scramble to buy the stock, but these returns often fall as the market corrects itself in the longer term. The study’s findings align with this hypothesis, showing that many IPOs that experience strong initial returns due to underpricing underperform in the following months and years. This pattern of initial excitement followed by market correction is a common feature in emerging markets, where regulatory oversight and market maturity are still developing.

In contrast to the impresario hypothesis, the signaling theory offers a different view on IPO underpricing. According to this theory, firms deliberately underprice their IPOs to signal their quality to investors, with the expectation that this strategy will lead to strong long-term performance. High-quality firms use underpricing as a signal to distinguish themselves from lower-quality firms, attracting investors who believe that the firm’s stock will rise in value over time. However, the study’s findings suggest that while this strategy may generate strong short-term results, it does not necessarily lead to better long-term performance. IPOs that are underpriced at launch tend to underperform after the initial excitement fades, as market corrections bring the stock’s value more in line with its intrinsic worth.

The empirical data presented in the study offers a clear picture of how IPOs perform over time on the CSE. Short-term abnormal returns are largely negative for up to 12 months after listing, reflecting the market’s tendency to correct initial overvaluations. However, by the end of the third year, BHRs turn positive, suggesting that IPOs can be a good long-term investment despite early underperformance. This finding is particularly relevant for investors in emerging markets, where volatility and uncertainty are often higher than in developed markets, but where long-term growth potential remains strong. The study recommends that investors hold onto IPO shares for extended periods, typically beyond two years, to take advantage of the eventual positive returns that tend to materialize over the long run.

The study also categorizes IPO performance based on the level of initial returns. IPOs with higher initial returns—those in the top quintile—perform significantly worse in the long run than those with lower initial returns. This supports the idea that early overpricing, driven by investor over-optimism or deliberate underpricing by underwriters, leads to poor long-term outcomes as the market corrects itself. In contrast, IPOs that generate lower initial returns tend to perform better over time, as they are less likely to be overvalued and therefore experience less dramatic corrections. This insight is valuable for investors looking to identify IPOs with strong long-term potential.

Firm-specific factors also play a significant role in determining IPO performance. The study finds that older firms and those with larger IPO sizes tend to outperform younger, smaller firms in the long run. Older firms are often more stable and better understood by investors, leading to less information asymmetry and lower risk. Larger IPOs, which typically represent more established companies, also benefit from greater investor confidence and stronger financial backing. However, younger firms, while more volatile in the short term, show strong recovery potential after the first year, suggesting that they may offer higher rewards for investors willing to take on more risk.

A particularly interesting finding of the study is the distinction between privatized IPOs and conventional IPOs. Privatized IPOs, which involve the sale of government-owned firms to the public, tend to perform significantly better than conventional IPOs in the long run. This is likely due to the perceived stability and lower risk associated with privatized firms, which often have strong market positions and established customer bases. In contrast, conventional IPOs, particularly those from smaller, younger firms, tend to underperform in the short term, though they may still offer positive returns over the longer horizon.

Market volatility is another key factor influencing IPO performance. The study finds that IPOs with higher market volatility in the early days after listing tend to underperform in both the short and long term. This is consistent with the divergence of opinion hypothesis, as high volatility is often a sign of uncertainty and conflicting investor expectations. In contrast, IPOs with lower volatility tend to perform better over time, as they are less likely to experience dramatic corrections and more likely to attract steady, long-term investment.

The study also breaks down IPO performance by sector, revealing significant differences between industries. For example, the plantation sector performs exceptionally well in both the short and long term, generating positive returns throughout the three-year period. In contrast, sectors like healthcare, energy, and services consistently underperform, with negative returns persisting over time. These industry-specific insights are crucial for investors looking to diversify their portfolios, as they highlight the importance of selecting IPOs from industries with strong growth potential.

Further analysis of the timing of IPOs reveals that those launched during "hot" periods, when investor activity is high, tend to perform better than those issued during "cold" periods. Hot IPOs generate higher returns both in the short and long term, while cold IPOs often struggle to gain traction in the market. This finding supports the windows of opportunity hypothesis, which suggests that firms tend to go public when market conditions are favorable, leading to better performance overall.

The study concludes with a series of robust regression analyses, which confirm the importance of factors like firm age, size, initial returns, and market volatility in determining IPO performance. These regression models explain between 10% and 22% of the variance in IPO returns, providing a solid empirical foundation for the study’s conclusions. The results are consistent with previous research in other emerging markets, though the study also highlights unique features of the CSE, such as the strong performance of privatized IPOs and the significant impact of investor sentiment.

In summary, this comprehensive study offers valuable insights into the performance of IPOs in an emerging market context, with clear implications for both investors and policymakers. By highlighting the factors that influence long-term returns and the importance of holding IPO shares for extended periods, the research provides a roadmap for navigating the complex and often volatile world of IPO investments in emerging markets.