Abstract
Despite underwriters' efforts to balance supply and demand in the IPO price setting mechanism, we show that the market accurately predicts (in the first-day return and volume) the direction but not the full magnitude of underwriters' pricing errors. That is, first-day winners continue to be winners on average (outperforming a size-adjusted benchmark) over the first year, and first-day dogs continue to be relative dogs. A trading rule of buy first-day solid beginning at the close of the IPO's second trading day outperforms the portfolio of first-day losers by about 14% in the next year during the 1988-1995 time period. An exception to this rule is the performance of extra- hot IPOs (with a first-day return greater than 50 to 60%) which are poor one-year performers on average. We also find that a measure of flipping, the dollar volume of sell-motivated block trades as a percent of total dollar volume on the first-day, has significant power to predict future returns, lending credence to investors' of cold IPOs as a rational strategy. Furthermore, we show that first-day flipping can be predicted from ex ante factors. Thus, we conclude that underwriters' pricing errors at both extremes (initial cold and very hot IPOs) are intentional and strategic.
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