Monday, 7 May 2012

Post IPO stock movements and company names.

Which company is more likely to gain in price shortly after floating?

TIM W.E. SGPS SA or Edwards Group Ltd.

The astute investors among you will tell me, possibly with a rather smug condescending smile, that a comparison is impossible without further information. We would need at least an opening price, financial statements some understanding of the product and its markets.......
However, in 2006 two Princeton academics published a paper entitled predicting short term stock fluctuation using processing fluency. This showed a high level of correlation between post-IPO share price and the name of a stock, the easier it was to pronounce the better the share performed after 1 week and 6 months. The effect was no longer statistically significant after a year.

To show this in monetary form they looked at $1,000 invested in the 10 most fluent and disfluently named shares in their study.  The fluent names produced a greater profit at all four points: $112 after 1 day, $118 after 1 week, $277 after 6 months and $333 after 1 year.

It appears that people are judging shares, at least when there is not much other information around, based on name. Why? Well, it comes down to the converging reactions we have when processing more or less difficult to comprehend information. 

The easier words are to comprehend the more familiar they feel. This relaxes us, leading to a more casual approach to thinking and a more trusting demeanour.  Conversely the harder something is to comprehend the less we like it, the more we doubt it and the more thoroughly we think engaging in what dual process theory refers to as system two.

When we read Edwards Group Ltd we are more likely to trust the company, our intuitions and buy. When we read TIM W.E. SGPS SA we are more sceptical and questioning of the share, it doesn't feel right and we don't buy.

So how do we use this to our advantage? Well once we've identified this there are two ways to deal with the situation depending on your intended exposure to risk.

If you are a long term investor attempting to gather constant returns over a long period. Stay away from IPOs; wait until companies have a long history of data to judge their performance by.

If you are happy taking on risk then the approach to take would be to go long easy to read IPOs, selling after a short time frame, you could also hedge exposure to cognitively easy shares by shorting harder to read IPOs.

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