Question

"IPO's are like hors d'oeuvers at a cocktail party. When the tray comes around, take some wether you are hungry or not." What does he mean by this statement? Does the IPO market provide evidence for or against the efficient market hypothesis? Explain.

Answer 1

Initial public offers or IPOs have for a long time been a segment of financial markets that have attracted a lot of speculators.

To understand the statement made in the question, let's understand what separates an IPO opportunity from a normal opportunity with any other existing stock trading in the market.

• Normally when an investor evaluates any existing stock trading in markets, he is looking at a price which has been determined by the market as a whole and therefore, any rapid spike or fall in the price is not expected unless any sudden event or news changes the underlying fundamentals and perception of the market. Large gains, hence come in due course of time as fundamentals of the underlying business change over time
• In case of an IPO, however, the IPO price of the stock to be listed is decided by the company's management and it could be substantially lower or higher than the overall market's view of the underlying value
  • It's important to note however, that if the IPO price decided by management is higher than market's view, the IPO may not attract enough applications and fail, or in some cases, too much speculative interest may attract enough applications for the IPO to go ahead but the stock may see rapid fall just after listing
  • On the contrary, if the IPO price is set lower than market's perception of the value of the business it may attract huge interest and get oversubscribed many times
• Therefore, it has been seen in the past that very often the freshly listed stock (through an IPO) witnesses rapid volatility on the first day of the listing as well as ensuing weeks and months.
• This opportunity to make rapid gains in a short span of time attracts a lot of speculators to the IPO situations.

Due to the above reasons, it's believed that due to normal human nature of wanting to make big gains in a short span of time, it's very tough for investors to stay away from IPOs and therefore, "IPOs are like hors d'oeuvers at a cocktail party. When the tray comes around, take some wether you are hungry or not"

Efficient market hypothesis:

Since an IPO price is decided by the company's management and it could differ substantially from the market's perception of the underlying value of the business, it's natural to see huge volatility in the price in the period immediately following listing, as the market adjusts the price of the security in line with its view of the underlying value.

Therefore, it can be said that IPO provide evidence in favour of efficient market hypothesis as the market discounts all available information about the stock just after its listing to value it according to the underlying fundamentals.