Optimism is good

Is the stock market, in the phrase made famous by one Martha Stewart, “a good thing”? In particular, is the thing called an initial public offering (IPO) also a good thing?

The usual answer to the first question is a qualified Yes. Although risky, investing in the stock market gives savers an alternative to bonds and bank deposits. The stock market also serves as a means for companies to raise what we call ‘equity’ capital.

The second question, on IPOs, is the subject of today’s column.

An IPO is a sale to the public of shares in a private corporation for the first time (hence, the description ‘initial’). The seller in an IPO is a closely held corporation; it is typically owned by its founders and a few investors.

IPOs are more likely amidst stock market bubbles that happen when stock prices are generally rising. A noted financial planner suggests that we are now in a stock market bubble.

Henry Ong opines, based on his calculations of something called the ‘market premium,’ that investor sentiment is back to normal or even better when compared with the bull market of 2014 to 2018.

It is then not a surprise that 14 IPOs are expected to be launched on the Philippine Stock Exchange this year, up from nine in 2022, and eight in 2021. Life is good.

Should you then wiggle your toes and tiptoe into the waters of “new beginnings”?

Perhaps you are more liquid than before the pandemic because there wasn’t much to spend on for two years. You felt that there were no cars to buy because there was no place to go anyway. You stayed at home with your face mask and face shield, the better to stay alive and healthy. And now things have changed.

My banker friend recalls the heady days of the Petron stock offering in 1994. It was then the largest IPO in Philippine history.

Unfortunately, those who invested in the IPO didn’t do well. The oil industry was deregulated in a way that adversely affected Petron’s business. The stock price of Petron stagnated for most of the late 1990s and the early 2000s. Still, the company has remained profitable thanks to its management.

But let us look at the matter in the light of the evidence. It is an open secret that IPOs are “hazardous to your wealth” (Loughran and Ritter, 1995). You would have done better investing in stocks that were not sold at IPOs. The sample data were from US corporations, but studies using data from other countries support a similar conclusion.

What explains the underperformance of stocks in IPOs? According to Loughran and Ritter, “…investors are betting on long shots.” But the investors are overly optimistic. They mis-estimate the probability of finding a big winner.

In short, the phenomenon can be seen as a “triumph of hope over experience.”

By now, it is well accepted that there is a psychology of fear and greed in the financial markets. When fear abounds, the market is gloomy and stock prices are moribund. The casino atmosphere of the stock exchange is nowhere to be enjoyed. Better to just go to the nearest bar, and drown your sorrows.

The opposite of fear is greed. When greed prevails, investors are overconfident. For them, it doesn’t matter which stocks they buy. They are Warren Buffett-invincible.

Everyone was also greedy in the roaring 1920s, as your grandpa would tell you if he were still alive. The crash of 1929 and the Great Depression then ensued.

So, should you invest your nest egg in an IPO? Or, should you go to the sidelines and let the braver souls do their thing? More generally, can you make money on other peoples’ emotions?

I speculated in both the stock and bond markets when I was much younger. I even did leverage, using a margin account to borrow from my stockbroker.

As an economics student, I thought I wasn’t exactly dumb. I followed Graham-Dodd’s ‘value-investing’ principles. I looked for solid companies with good management and products in high demand. I found Gulf Oil, Clark Equipment, and Dr Pepper. I must report that I didn’t make much money; I may even have lost some, but this was so long ago, and my memory has faded.

You may then want to ask: Do academic economists make money in the financial markets? My first answer, from personal experience, is a resounding Nyet. Based on the academic literature, my second answer is a confirmatory Nyet again, but with a theoretical story behind it.

The theory is that if any one expert can predict the future of the financial markets, he would be immensely rich from arbitrage (you know the old saw – ‘buy low, sell high’).

Our expert would have to have prescience or foreknowledge. It is as though he could travel to the future, and then back to the present so that he can invest in ‘sure winners.’

The infamous Bernie Madoff had an untold story of time travel. He made up trading records based on past data to report ever-steady and abundant profits. The bogus trading records were in the statements that Madoff gave his clients.

But what happens if such foreknowledge is elusive or inexistent? A famous economist, Deirdre McCloskey, restated the question: “If you’re so smart, why aren’t you rich?” She called it the American Question.

The answer is surprisingly simple. With everyone working at being the smart one, no one investor can beat the rest of the market. If there were such an investor, he would end up owning the entire economy.

But nobody does. (A few can get lucky once in a while or even spectacularly, but that is all.) The explanation is based on crowd behavior. If everyone in a crowd stood up to see what was going on, no one would see what happened.

It is then a futile and seemingly Jobian exercise to bet your money on an IPO. The Biblical Job suffered misfortunes because God was testing his fortitude.

Those who subscribe to an IPO must likewise face a test of fortitude. They must believe in the fortunes of the newly- expanding corporation.

Where does the belief originate? A New Yorker cartoon suggests that investment is boring until the one selling the investment has a neat story to tell.

In an IPO, underwriters usually come up with a good story to go with the IPO. Ironically, the investor with little fortitude is the one who benefits by not participating in the IPO.

If the story isn’t true or is vastly exaggerated, I submit that in this case, an IPO behaves like a Ponzi. Note that a Ponzi is a form of fraud that supports a belief in the success of a non-existent enterprise. Quick returns paid to the first or early investors foster this belief. The payments to the early investors come from money ‘invested’ by later investors.

There is then a thin red line between IPOs and Ponzis, and it has to do with the existence of ‘enterprise.’ Are the expected future profits or returns real? If perception is ‘reality,’ the dividing line may be hiding in plain sight. The IPO is like a Ponzi if the enterprise exists only in the minds of investors. You can almost read the mind of the company launching the IPO: “Take the money…run.”

A Ponzi is good only for the operator and the early investors. The sad fate of late investors here is akin to that of those who invest in IPOs.

This explains to an extent the recorded under-performance of stocks at IPOs. We can consider the investors at the IPO as subject to the classic ‘winner’s curse’ in auction markets. The winner is the one who valued the object the most. If he were, later on, to change his mind, for whatever reason, he is not likely to find a buyer at the price he paid.

The curse leads to ‘buyer’s remorse’ which leads winners to re-evaluate, and later sell.

The lesson here is that one should not try too hard. Even the smartest can’t be rich, and they would grudgingly concede that luck matters. The incorrigible but lucky gambler would be our hero.

The last somber word is from Ecclesiastes (9:11): “.. the race is not to the swift or the battle to the strong… but time and chance happen to them all.”

Author’s email: ORoncesval4@gmail.com; Twitter: @ORoncesvalles