INVESTORS PSYCHOLOGY TOWARDS IPO GRADING
The Securities Exchange Board of India (SEBI) introduced the grading system for initial public offering (IPO) in January 2007 on optional basis and made it mandatory from May 1, 2007. This initiative has improved the business of credit rating agencies and made the fundamentally strong companies feel happy while put the fundamentally poor companies in a dilemma but failed to change the disposition of the investing community. It is a fact that some companies with poor grading have withdrawn from issuing IPOs and many of them are approaching another rating agency for their IPO grading. Everybody in the market strongly believes that the regulator may come out with many crucial issues like IPO pricing of unlisted companies and uniform face value for shares in the forthcoming board meeting.
No other country in the world carries out IPO grading and therefore it is necessary to see the usefulness of the process. Initial Public Offering, also referred to simply as a "public offering," is the first sale of stock by a private company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it's known as an IPO. IPOs can be a risky investment for investors. For the individual investor, it is tough to predict what the stock will do on its initial days of trading and in the near future since there is often little historical data with which to analyze the company. Also, mostly IPOs are done by the companies which are going through a transitory growth period, and they are therefore subject to uncertainty regarding their future value.
IPO (Initial Public Offering) grading is a service aimed at facilitating the assessment of equity issues offered to investors. The grade assigned to any individual issue represents a relative assessment of the 'fundamentals' of that issue in relation to the other listed equity securities in India. Grades are assigned on a scale of 1 to 5 with a higher (5/5) score indicating stronger fundamentals and a lower score (1/5) indicating poor fundamentals. This move of SEBI is yet another initiative to safeguard the interests of the retail investors who are comparatively new to the capital market. As IPO grading represents an independent opinion from an agency that is not connected with the placement of the issue and has an ongoing incentive to maintain its reputation for independence and analytical rigor. IPO grading is not a recommendation to invest in the graded instrument. It is not a comment on the price of the graded security or its suitability for a particular investor. It does not comment on issue price, likely price on listing or movement in price post listing.
The researchers particularly insist the Indian retail investors to be new because they hesitantly divert their savings towards the volatile market as they are accustomed of getting heavy interest rates on their savings till a few years ago. With falling interest rates the educated population has now started to slowly divert some part of their savings in the fast growing capital market.
SEBI’s guidelines for IPO grading
The Securities and Exchange Board of India (SEBI) had first experimented IPOs grading on optional basis. But on the other hand, none of the promoters and lead managers voluntarily chose to be graded even at no cost to the companies concerned. This has led SEBI to make IPO grading compulsory for all.
The important features of SEBI's decision on IPO grading are as follows:
The grading exercise will exclude the issue price from its scope;
It will be carried out by recognized credit rating agencies;
The grading will be on a 5-point scale, the lowest grade to be indicated by 1 and the highest by 5.
The issuing company will be allowed to choose the rating agency for grading its IPO.
The main criticism voiced against SEBI's decision has been that it excludes the issue price from the scope of grading. The critics have argued that the issue price is a crucial factor in determining the worthwhileness of an IPO from the investor's viewpoint to include it.
However, it can also be argued that the rationality of the price itself depends on the IPO's fundamental quality. Determining the quality is a very complex work which is beyond the competence of most investors. That is why so many poor quality and even fake IPOs get subscribed. Grading of IPOs in terms of their fundamental quality will enable investors steer clear of unsound and fraudulent IPOs. Such IPOs are likely to be restrained by the grading system as they will be in the bottom grades of 1 and 2.
The qualitative analysis of IPOs has to include factors such as business prospects of the company and the industry, company's competitive strength, management's competence and integrity, quality of corporate governance, reliability of the company's accounting and audit system, etc.
Assessment of IPO grading
From the discussion made earlier, it is clear that it is vital for an investor to take a look at the fundamentals of the company in which they wish to invest their hard earned money. This is probably the reason why SEBI has initiated IPO grading, with the help of which an investor is in a position to take a close look at the company's activities and the risk involved in investing in the company in the long run. However the following points regarding the same are worth noting:
The grade assigned to an issue represents relative assessment of the fundamentals of that issue. It is a onetime assessment and has no ongoing validity.
IPO grading totally ignores the valuation aspect of the company's IPO.
The grading does not aim to indicate the likely returns from the IPO to the investor for his investment.
The IPO grading also does not take into account market factors such as liquidity, demand, supply situation of the scrip, the market sentiment at the time of issue and so on. This information is also important from the investor's point of view.
From the above points researchers feel that there is lot of scope for improvement in IPO grading system. Although SEBI has made it mandatory to get IPO grading done, the parameters and grades are not standardized so it becomes necessary for SEBI to standardized parameters. The market factors such as liquidity, demand, supply, situation of the scrip, market sentiments at the time of issue, etc. are not taken into consideration and the very purpose of protecting the interest of the investors is defeated. This is mainly because pricing of the issue is the most crucial determinant of returns to the investors and it is not included in the grading process. A fundamentally strong issue priced aggressively may not leave much for the investors after listing. In fact, investors might lose money on such aggressively priced IPO. On the other hand, if investor puts money in the IPO of a fundamentally poor company, that is also priced very low, profits are likely accrue after listing. As said IPO grading may not affect the fundamentally strong companies to be subscribed but only with poor fundamentals. It is a fact that some companies with poor grading have withdrawn from issuing IPOs and many of them approaching another rating agency for their IPO grading.
The approach to IPO grading is very alike to the research architecture that is available to bond markets in the form of credit ratings. A credit rating is a relative assessment of the fundamentals of the bond security. Likewise, IPO grading is relative assessment of the fundamentals of the equity security. IPO Grading is value adding to the investment process of institutional investors due to the independent and focused information on relative fundamentals that is contained in the IPO Grading rationale. Moreover, the expression of the independent opinion on relative fundamentals as a single unambiguous symbol creates the possibility of discovering meaningful relationships between fundamentals and pricing. It may be noted that institutional investors extensively use credit ratings in the market for privately placed bonds where credit ratings are not mandatory.
REVIEW OF LITERATURE
Pandey & Kumar (2001) found that IPOs creates potential agency problems and associated costs by the outside investors. The potential conflict of interest problems between insiders and outsiders could be very high in countries with weak corporate governance mechanisms like India. Crouzet Faugeron et al (2003) researched at two competing hypotheses to explain IPO underpricing in France when a seasoned offering follows the IPO. They found evidence in favor of the signaling hypothesis in the case of fixed price IPOs. For the auction-like procedures, they showed that the initial investors' demand, rather than post-IPO performance, determined the type of security that was issued, but had no effect on the financing decision itself. The market feedback hypothesis was therefore only weakly supported. Carter et al (1990) examined that the returns earned by subscribing to initial public offerings of equity and found that more informed investors’ capital required higher returns. Berglund (1994) presented a model that explains a number of empirical observations on initial public offerings. The model assumed that the firm which intends to go public is best informed about the future prospects of the firm. The analysis depicted that under reasonable conditions under-pricing will arise. Aggarwal (2000) found that aftermarket activities are less transparent and include stimulating demand through short covering and restricting supply by penalizing the flipping of shares. In her study she analyzed that more than half of IPOs, a short position of an average 10.75 percent of shares offered is covered in 22 transactions over 16.6 days in the aftermarket, resulting in a loss of 3.61 percent of underwriting fees. Chemmanur (1993) presented an information-theoretic model of initial public offering pricing in which insiders sell stock in both the initial public offering and the secondary market, have private information about their firm's prospects, and outsiders may engage in costly information production about the firm. The study depicted that the information reflected in the secondary market price of equity gives a higher expected stock price for high-value firms.
Tinic, Seha M (1988) researched that IPOs of common stocks were typically underpriced and found that the results, based on samples of IPOs of common stocks that were brought to the market before and after the Securities Act of 1933, provide considerable support for the implicit insurance hypothesis. Aussenegg et al (2006) studied IPO pricing in Germany to determine whether when-issued trading provides information that was useful for setting IPO offer prices, and whether such trading supplants book-building as a source of information. They found that relevant informations for pricing IPOs were revealed, and that, once when-issued trading has begun; book-building is not a source of costly information for pricing. But book-building does not appear to be fully supplanted as a source of pricing information. Boehmer et al (2006) found that initial institutional flips help predict future returns and suggested that at least some institutions retain valuable private information about IPO firms. Their study depicted the importance of aftermarket relations between underwriters and investors. Fernando et al (2002) researched that when firms go public in an IPO, they must choose a number of shares to offer and a price level for those shares. They found that the relationship between IPO price level and under pricing was U-shaped, and demonstrated economically significant differences across firms choosing different IPO prices in the amounts of money left on the table due to under pricing. They also found that institutional ownership and underwriter reputation were greater at higher price levels, and that post-IPO turnover was lower for high-priced IPO’s than for mid-priced IPO’s. Jain and Sharma (2008) in their paper explored and explain the concept of IPO grading and its underlying rationale. They provided an objective evaluation of the costs and benefits associated with IPO grading.
To develop and standardize a questionnaire for analyzing the investors psychology towards IPO grading.
To analyze the underlying factors of investors psychology towards IPO grading.
To open new vistas for further research.
The study was exploratory in nature with survey method being used to collect the data. The total population includes the retail investors of Gwalior. The sample size was 100 retail investors and individual respondent was the sampling element. The non-probability sampling technique was used. A self-designed questionnaire was used for taking the responses of the retail investors’ likert-type scale of 1to5. The tools used for data analysis were item to total correlation which was applied to check the consistency of various items used in the questionnaire. For testing the reliability, Cronbach alpha was applied to the items and validity of the questionnaire was checked using face validity method which was found to be high. Finally in order to find out the factors affecting investors’ psychology towards IPO grading, factor analysis was applied using SPSS 13.0 software.
RESULTS & DISCUSSION
Consistency of the Questionnaire: The consistency of all the items in the questionnaires was checked through item-to-total correlation. Correlation of every item with total was measured and the computed value was compared with cut off value or standard value of 0.19422 as per table-1. The computed value was found high and so none of the item was dropped.
Reliability: For checking the reliability of the questionnaire, Cronbach Alpha was calculated by using SPSS 13. The reliability value was found to be 0.782 (See table 2). The reliability of more than 0.7 was considered good. Thus the reliability of the questionnaire was found good.
No. of Items
Factor Analysis: Factor Analysis using principal component Varimax rotation was applied on the raw scores of 10 items to find out the factors that contribute towards investors’ psychology towards IPO grading. These factors are briefly introduced below as per table 3:
Articulacy: This factor has emerged as the first important determinant of research with a total variance of 3.474. Major element consisting this factor include legal formalities for IPO grading(0.722), IPO grading as a way of showing company performance (0.713), benefit to investor (0.713), transparency in IPO grading process (0.597). In this research it was found that articulacy plays a major role in IPO grading.
Regulatory: This factor has emerged as the second most important determinant of research with a total variance of 1.327. Major items consist in this factor are awareness about IPO grading (0.792), Institutionalization (absorption by organization) of IPO grading (0.666), and compulsion/mandatory of IPO grading (0.655). During this research it was found that responsiveness plays a vital role.
Reliance: This factor has emerged as the third most important factor of research with total variance of 1.031. Major items consisted in this factor were Trust on SEBI’s guidelines regarding IPO grading (0.835); Recommendation for buy holds or sells decision (0.604), Trust on credit rating agencies (0.562). During the research it was found that reliance of retail investors on credit rating agencies and SEBI’s guidelines are incredible. Jain & Sharma (2008) said mandatory IPO grading by Credit Rating Agencies for assessment of 'fundamentals' of issuer companies had provided an additional investment guidance tool for the unsophisticated investors.
IMPLICATIONS OF THE STUDY
This study is intended to be a useful contribution to the academicians to understand the investor’s psychology towards IPO grading.
It will also contribute to the retail investors, which are taken as the sample because it provide a knowledge about the different features of IPO grading
This research is also helpful in taking decisions related to capital market.
Parameters for grading and grades should be standardized.
The valuation aspect of the IPO should also be taken into consideration while grading so that it can be of much use to the retail investors.
A few of market factors such as liquidity in the market demand and supply of the script, market sentiment, etc. should also be taken care of while grading an IPO.
The study revealed that there is awareness in the retail investors towards IPO grading; they have sufficient knowledge about IPO grading. Retail investors play a key role in any economy. These are the people who have high degree of risk and try to make the right decisions to make their investment profitable. The analysis reveals that factor like articulacy shows that IPO grading is beneficial for the investors and investor think that the IPO grading process is transparent too. They think that IPO grading process help them to know the performance of the company. The factor regulatory shows that investors are well aware of the IPO grading and they are satisfied with the compulsion of IPO grading. The factor reliance shows that the investors have trust on SEBI’s guidelines regarding IPO grading and they also have faith on the credit rating agencies who give grade to the companies after a long research. At last on the basis of research we can conclude that IPO grading is beneficial to the investors because it’s a way of showing company performance it shows whether the fundamentals of the company is strong or poor on the basis of which investors can decide about their investment decision. Although it is a new concept but it is highly accepted by the public as per our results.
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