07 Jun The Singapore O&G IPO – Do Investors Overreact to Stock Prices?
Obstetrics and Gynecology firm O&G Singapore debuted on the Catalist Board last week.
The company had hoped to raise 10.9 million with the issuance of shares at 25 cents a piece. At that price, the PE ration is 12.8x, an extremely conservative valuation by today’s standards.
Brian from A Path to Forever Financial Freedom has done a great write up on it prior to the IPO. I have no qualms that it is a great stock to own at that price. I was not the only one apparently – the IPO was oversubscribed by 18x.
On the first day of trading, it opened at 45.5 cents, almost doubling on its placement price. On Friday, the second day of trading, it closed at 67.5 cents, inching towards a 300% gain for the
lucky punters shrewd investors.
The Initial Public Offering created quite a stir in an otherwise flaccid IPO market. It’s been a while since we have seen such keen interest followed by the astronomical rise. In fact, the other time in recent memory where I had friends and colleagues who were passive investors talk to me about an IPO was five years ago when GLP listed.
It brings to mind the IPO heydays of the early 2000s. I remember making many a trips to the ATMs hoping to get lucky.
Does the Stock Market Overreact?
The O&G IPO also brings to mind a classic study done by Werner De Bondt and Richard Thaler in 1985. The paper is titled Does the Stock Market Overreact?
At that time, the works of social psychologists Amos Tversky and his Noble Prize Winner collaborator Daniel Kahneman was fast gaining prominence. Amongst the phenomenons they discovered then and remained highly relevant till today are the heuristices of representativeness and availability.
Simply put, representativeness heuristic occurs when people judge a known event by finding another comparable event and assuming they are similar (hence the representativeness). The availability heuristic is a mental shortcut that relies on immediate examples that comes to a person’s mind. What is more immediately ‘available’ becomes more ‘important’ in decision making.
With these biases in the background, De Bondt and Thaler came to the realisation that people do not make decisions rationally. Their decisions were distorted by the vast amount of cognitive errors they have to contend with.
They were keen to discover how much of this is translated into stock prices. Are stocks priced correctly at all? Do investors overreact when it comes to stock prices? If they do, does it mean that stocks that exposed to good news have become over-priced? Could it be that stocks that have had a bad run are actually undervalued in comparison with the general market? They set out to test their hypothesis.
They did so by mining price data for the New York Stock Exchange (NYSE) from January 1926 to December 1982. In the process, they created ‘Winner’ and ‘Loser’ portfolios of 35 stocks each. These are the top and bottom performing stocks for the entire market at each rolling time period.
The hypothesis is straightforward. If there is no overreaction involved, the winners will continue to outperform while the losers will continue to languish. However, if human beings being the imperfect decision makers they are display overreaction to stock price on the basis of good or bad news, the winners will eventually perform in a worse off fashion than the general market. And stocks in the loser portfolio will eventually catch up.
This is what they found.
To quote directly from the paper
Over the last half-century, loser portfolios of 35 stocks outperform the market by, on average, 19.6%, thirty six months after portfolio formation. Winner portfolios earn about 5% less than the market. This is consistent with the overreaction hypothesis.
From the outcome, there is little doubt investors get caught up with euphoria and over pay for stocks having a good run. They also become fearful of poor performing stocks, selling them and causing their prices to fall beyond what is reasonable. #overreaction
Two other details about the study caught my attention.
DeBondt and Thaler choose the time frame of 36 months because it is consistent with Benjamin Graham’s contention that ‘the interval required for a substantial underevaluation to correct itself averages 1.5 to 2.5 years’. As the graph has shown, most of the reversal took place from the second year onwards. This is consistent with Graham’s observations. It takes time for the market to eventually function as the proverbial weighing machine.
Secondly, the overreaction effect is larger for the loser portfolio than the winner portfolio. Stocks that have been beaten down due to investors overracting to their bad performance eventually recovered faster and more than stocks whom investors have overvalued.
Many have credited this study as a catalyst for the development of this entire field known as behavioural finance. Behavioural finance understands that everything finance has an important human element. To understand finance we have to understand human. Behavioural finances incorporates psychology to explain stock market anomalies.
Perhaps one day in the future we may look back and discuss about how investors have overreacted to the listing of O&G, driving its price up to unrealistic levels. Perhaps this would become the tipping point for our capital markets to roar back to life, with investors piling into IPOs after IPOs now that the success of O&G lies fresh in their minds. Perhaps we might even take a second look at other healthcare counters in the hope that they take the same shine as O&G. These are phenomenons that cannot be explained by traditional finance theories.
As I write about this 30 years on, it has become widely acknowledged that human beings are imperfect decision makers especially when it comes to the issue of investing and money. We are driven by emotions – greed and fear. We make sub-optimal decisions all the time. We overprice stocks when they are doing well and we undervalue them when the company is having a bad run.
Understanding how our biases and emotions affects our decision making will lead us to become better investors.