Idle speculation about anchoring and the Facebook IPO
Facebook IPO’d at a price of 38 dollars a share, which apparently gave it a price-to-earnings ratio in the range of 100 - extremely, fantastically high. The price dropped pretty rapidly and is currently somewhere around 20 dollars; which still, presumably, gives it a very high P/E ratio somewhere in the forties. Now, suppose it had IPO’d at a more historically-reasonable P/E of, say, 20 - still high, but not stratospheric. That would put the initial share price somewhere around 10 or 12 dollars. Is there any strong reason to believe that the price would then have *risen* to where it is now? It is not obvious to me that the current price is supported by anything but the historical price—in other words, it’s trading around 20 because it has recently traded around 25.
My point: I can’t help but wonder if someone connected to the IPO had read Kahneman on anchoring. Somebody, clearly, was buying the stock at 33, just as someone is still buying at 20; I wonder if the chain of thought had that apparently-arbitrary number “38” in it somewhere, making 33 look cheap—fundamentals be damned! And if this happened, who benefited, and what ought we to conclude about the efficiency of markets?
There is a huge literature on behavioral economics and financial markets. Better to engage with that than post on a single anecdote, I think.
RolfAndreassen, if you have a theory that allows you to predict particular inefficiencies in very liquid markets like stocks, then you could easily make huge amounts of money (PM me if you need help doing so). The fact that you haven’t done so (if, in fact, you haven’t) puts your particular hypothesis in a reference class of hypothesis that aren’t even worth considering seriously.
While I agree with your sentiment, I think this is just begging the question—you are rejecting this speculation by assuming homo economicus.
How seriously would you take a non-wealthy person’s claim to know a reliable way to win the lottery? I’m not so much assuming homo economicus as just taking the outside view.
He’s trying to figure it out. He hasn’t got a theory to predict this in advance. He’s just observed, ‘dang, that looks like it was inefficient’.
How would you exploit that for your monetary gain?
Serious question: how would you take putative knowledge that IPO prices are sometimes set too high for the reasons Rolf gives (or even that stock prices in general are subject to anchoring bias or exhibit hysteresis) and use it to make huge amounts of money, particularly given a limited initial bankroll? I am clearly not an economist, so even a rough sketch would help me understand.
Presumably, if you know a stock is too highly priced at its IPO (or any time, really), you short it. Unfortunately the hypothesis “some IPO prices may be subject to manipulation by insiders who know about the anchoring bias” doesn’t tell you which ones. I suppose you could try systematically shorting every IPO that comes along, but presumably if that were a viable strategy someone would already be exploiting it; it’s too simple not to have been spotted. Besides, I think the transaction costs are too large for a small player to make any money with this sort of strategy.
Seems to me that prices on stocks subject to this sort of manipulation aren’t going to be distributed similarly to those that aren’t. I have no idea of what either distribution would look like in practice, but it seems like you ought to be able to make some money by preferentially picking your shorts based on the points at which you’d expect them to differ—the OP’s price-to-earnings ratio being one candidate.
How much money depends on how distinguishable this is from a normal shorting strategy, how common this kind of insider manipulation is, and how much noise there is in the system, though. I wouldn’t expect it to be a spectacular win in most cases, just a minor advantage.
You need more than an accurate prediction- you need a prediction which is more accurate than the competition’s. The stock market is a small-sum game played against other agents, not a zero-sum game against chance.
Which insiders care about the current price of Facebook stock and had power to pick the IPO price?
Zuckerberg et al are independently wealth if Omega appears tomorrow and crashes Facebook.
The investment bankers organizing the IPO have made the money that they were going to make on the transaction.
Lower level insiders might care about the current share price and have the insight that anchoring the price would provide support—but did they have power over the IPO price?
More generally, there’s no reason but ego for Zuckerberg to want the share price to climb from the IPO price. As explained here, first day increase over the IPO is really collected by the investment bankers, not the business creators.
In other words, there is a satisfactory explanation for why the IPO price was high compared to the general trend of share price. Do you feel that explanation is insufficient for the observed behavior?
Maybe I’m being slow: I don’t understand what explanation you refer to. You give arguments for why each of the groups involved in the IPO either had no motive, or no power, to over-price the stock; but I don’t see where you give an alternate explanation. I suspect an underestimated inferential distance; can you clarify?
It’s mostly in the first section of the linked article. In brief, business insiders (Zuckerberg et al) get paid the IPO price for their shares. Any increase from that price accrues to whoever bought first.
In recent history, that was investment banker insiders, not business insiders (ignoring for a moment the retained holdings of the business insiders). That windfall is practically the definition of positional rent since it exists only because the I-bankers are the conduits between private companies and the public market. Remember that the I-bankers were also paid a large fee by Facebook to facilitate the IPO. And any first-day-IPO profits are practically risk free to the I-bank insiders (especially before the Facebook IPO, when every offering was expected to jump a bit in price).
In short, I think Zuckerberg analyzed the situation and decided to set the price to maximize the proportion of the cash created by the IPO that ended up in the hands of business insiders rather than I-bank insiders.
It’s possible that business insiders like Zuckerberg care about the share price. But they are independently wealthy regardless of the shares. And this close to the IPO, securities laws make the remaining insider holdings somewhat illiquid. And business insiders keep shares to retain control—wealth maximization is important, but not an immediate focus.
One could spin a story about how opening day performance of an IPO is good for the company—but I’m not persuaded. And even if that were true, does it justify what is effectively transferring wealth from business insiders to I-bank insiders?
Ok, now I see what you’re saying. However, it seems to me that every pre-IPO shareholder in every company has an incentive, from this argument, to push for a higher IPO price, while the bankers have an incentive to hold the price down. So what made Facebook unusual?
That aside, your point remains good for showing that my speculation is probably off, even though it doesn’t in itself explain Facebook’s trajectory.
I-Banker incentives are complicated. On the one hand, potential clients select among them based on their ability to generate wealth for the client (pushing IPO prices up). On the other hand, they have tremendous opportunity for self-dealing transactions (pushing the IPO price down). The balance is apparently in flux.
Facebook may have been unusual because Zuckerberg’s particular special skills seem to resolve around analyzing and monetizing social interactions. Those skills may have helped him maneuver the I-bankers better than the average going-public entrepreneur.
In a couple years we’ll know whether the Facebook IPO was a trend or a blip in the pattern of IPOs. Blip supports the Zuckerberg-IPO-insights theory, while a larger trend suggests the opposite.
The people who benefited from the high IPO price were those who already had shares, because they could sell them high.
I think price levels have been systemically detached from P/E ratios for a long time. My impression is that market averages are set by indirect control of liquidity levels, by central banks acting according to political criteria. So the “rational” price level might be set by P/E ratio, adjusted by a political multiplier.