Working Paper: NBER ID: w18555
Authors: Zhi Da; Ravi Jagannathan; Jianfeng Shen
Abstract: We provide empirical support for the conventional wisdom that there are times when optimistic investors tend to build their hopes into castles in the air, and pay a large premium over intrinsic value for stocks of firms in the early stages of their life cycles with perceived growth opportunities. We use industry IPO waves containing a set of firms in the same industry that went public at about the same time in a cluster to identify those time periods and firms that are relatively homogenous and in the same early growth stages of their life cycles. We find that three years after an industry IPO wave ends, among the firms in the wave with relatively high historical sales growth rates, those with low gross margins are over-valued relative to firms with high gross margins. They under-perform their industry IPO wave peers by 0.92% per month, or about 12% per year, during the subsequent four-year period after adjusting for risk and firm characteristics differentials. Further, the average future returns on these firms are even below the corresponding risk-free returns. Our findings contribute to the literature on inefficient capital markets by identifying situations when prices of some stocks are likely to be affected by bounded rationality or biases in the way investors make decisions, and agency issues limit the ability of more sophisticated arbitrageurs who have to rely on other people's money from exploiting any resultant profit opportunities.
Keywords: IPO; Investor Behavior; Market Valuation; Gross Margin; Bounded Rationality
JEL Codes: G02; G10; G12; G14; G17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor optimism (G31) | Underperformance of low-margin firms (L25) |
| Overvaluation of low-margin firms (G32) | Long-run underperformance (D29) |
| Industry IPO waves (G24) | Overvaluation of low-margin firms (G32) |
| Low gross margins and high sales growth (L25) | Overvaluation of low-margin firms (G32) |
| Low-margin firms (D22) | Negative excess returns compared to high-margin firms (D22) |
| Low-margin firms (D22) | Below risk-free returns (G19) |
| Low-margin firms (D22) | Do not achieve higher market share or improved profitability (L19) |