1.     Literature review and Hypotheses

Literatures use the terms first-day returns and
underpricing interchangeably. The first day return or the initial return is
measured using the closing price of the first day. Studies show that there is a
systematic increase from the IPO’s offer price to the first day closing price.
Ritter et al. (2002) shows that in a sample of 6,249 IPOs from 1980 to 2001 the
average first-day return is 18.8 percent, and proximately 70 percent of the
IPOs finish the first day of trading at a closing price greater than the offer
price. The average IPO underpricing, 18.8 present, is unlikely to be a result
of misevaluation or asset-pricing risk premia because of the magnitude of the
underpricing and the inability to explain why the second-day investors
purchasing from first-day investors do not require this premium. Usually,
fundamental risks or constraints are not resolved within one day. Clearly, The
difference in the perceived value of equity between the issuer and the
investors results in IPO underpricing. This perception is subjected to various
endogenous and exogenous factors working to mitigate or emphasize the
underpricing.  They state “no exceptions
to the rule that the IPOs of operating companies are underpriced, on average,
in all countries.”

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Asymmetric Information and signaling theory state that when
the investors have less information, they fear a lemon problem, that only low
quality issuers are the one who initiates the IPO. As a signal of high quality
and to distinguish themselves from the lemons, the high quality issuers intentionally
underprice their shares, which deter lower quality issuers from imitating. Therefore,
based on the model, degree of underpricing is positively correlated with the
firm quality. This money that was left on the table defined as the number of
shares sold times the difference between the first day closing price and the
offer price leaves a good taste in investors mouth and can thus be exploited as
an increase in in the demand on the seasoned equity offering (Welch, 1989), responses
to future dividend announcements (Allen and Faulhaber, 1989) and analyst
coverage (Chemmanur, 1993).  Therefore,
the expected benefit derives from the post IPO’s activities (e.g., SEO) exceeds
the signaling marginal cost.

However, although (Welch, 1989) claim that an explanation of
the IPO underpricing is the signaling theory, providing evidence of the
substantial post-issuing market activity by IPO firms, there is a reason to
believe that price appreciation would induce issuers firms to return to the
market for more equity funding as (Ritter, 2002) states. In fact, (Jegadeesh,
Weinstein, and Welch, 1993) state that under the signaling theory issuers are
(a) Firms with higher IPO returns are likely to issue larger amount of seasoned
equity than firms with lower IPO returns. (b) Likely to issue larger amounts of
equity in their seasoned offerings; (c) likely to issue seasoned equity more
quickly after the IPO; and (d) likely to experience a smaller price drop when
the SEO is announced.

Also, (Beatty and Ritter, 1986) demonstrate that there is a
positive relation between the IPO underpricing and the uncertainty of investors
regarding its value. As the uncertainty regarding the issue increases, investors
will demand that more money be ‘left on the table’ and thus more underpricing.  

When the investors have more information about the general
market demand for shares, the issuers face an allocation problem.  (Rock, 1986) model assumes that investors are
differentially informed, obtaining information is expensive for the investors, and
thus higher pricing leads to a winner’s curse among uninformed investors. The
issuer is interested in attracting both classes of investors to make the issue
successful because full subscription is related to the level of participation
by uninformed investors. Also, uninformed investors are perceived as strategic
investors and investment by them is normally targeted for a longer period.

Also, a related issue to the investors having more
information about the demand is the informational cascade theory (welch, 1992).
The theory assumes that sequential IPO shares selling leads potential investors
to learn from the purchasing decisions of earlier investor. This creates
herding effect due to dynamic information and investors completely ignore the
information obtained by them.  Demand can
be so elastic and the offerings succeed or fail rapidly based on the pricing.
Pricing just a little too high indicates a high probability of complete failure
because the later investors abstain based on the first investors abstinence.
Therefore, an issuer may underprice in order to guarantee the offering to
succeed and may want to reduce the communication among investors by spreading
the selling effort over a more segmented market. The process of bookbuilding
might mitigate the underpricing issue since it allows underwriters to obtain
information from informed investors and set the price accordingly. Book
building works as a reduction of the variance in the magnitude of information
asymmetry between various classes of investor by allowing flexible bids by
prospective investors within a predetermined price range.


            However, (Ritter, 2002) states non-rational
and agency conflict explanations offer considerable promise of explaining the

Firms’ visibility in emerging markets is more
pronounced because the majority of traders are individual traders, which gives
us the opportunity to test the effect of individual recognition and firm’s visibility
on trading behavior.  Therefore, emerging
markets can serve as laboratories for studying the relationship between market
irrationality and underpricing issue. 


Investor Recognition and IPO

Physical, legal, and information
obstructions can impede capital flows and lead to segmented inefficient global
financial markets. Advances in technology and regulatory reforms have reduced
many of these barriers to trade; however, philosophical, cultural, and
religious differences might produce barriers to trade and investigating them
might provide significant new economic insights.

Emerging markets might serve as laboratories for studying
the relationship between market barriers, financial market integration, and
economic efficiency. Particularly, the Islamic emerging financial markets
represent a unique opportunity to observe the impact that cultural differences,
in the form of religious investment restrictions, can have on the efficiency of
the underlying financial markets.

Prior studies show recognition by investors can be affected
by media coverage (Fang and Peress, 2009), firm geographic location (Loughran
and Schultz, 2005), initiation of analyst coverage (Irvine, 2003), hiring of
investor relations firms (Bushee and Miller, 2012), and increases in
advertising expenditures (Grullon, Kanatas, and Weston, 2004). (Asem et. al,
2016) show that Sharia stock classification affect firm’s recognition by equity
market’s participants. They link investor recognition to stock liquidity by
showing that Sharia stock classification acts as a source of information
dissemination to outside investors.

Islamic scholars provide important information
to potential investors by screening firms in order to classify them as Islamic
or conventional. Depending on each investor’s adherence to their beliefs,
Islamic investors typically refrain from firms that are not Islamic
(conventional stocks) and will only demand Islamic firms. In contrast,
conventional investors will demand firms’ stocks regardless of their classification.
Therefore, a wider base of both Islamic and conventional investors in Saudi
Arabia will demand Islamic firms’ stocks, while conventional firms’ stocks will
be demanded only by narrower base of investors.

Moreover, in asset pricing field, the idea that
“neglected” stocks earn a return premium over “recognized” stocks has been in
existence for many years (e.g., Arbel et al., 1983). Therefore, since Islamic
stocks are traded by both Islamic and conventional investors and have broader
clientele and, thus, have higher media and analyst coverage, which leads to a
higher degree of investor recognition. In Merton’s (1987) framework, firm
idiosyncratic risk is priced because of the imperfect diversification that
stems from a lack of investor recognition. Firms with higher idiosyncratic
volatility should offer a return premium to compensate shareholders for the
undiversified risk they impose. Therefore, conventional firms have higher
idiosyncratic risk since they are not traded by all the market participants and
this risk should be compensated. (Asem et. al, 2017) show that Islamic stocks
have lower idiosyncratic volatility, indicating that Islamic stocks are held by
broader investor base than conventional stocks. The same argument can be stated
regarding the IPO underpricing; since conventional firms have higher
idiosyncratic risk because their stocks cannot be traded by all the market
participants and this risk should be compensated, this compensation might comes
as in increase in the initial return (more underpricing).  Moreover, since conventional stocks cannot be
traded by all the market participants and have less recognition, the
uncertainty of investors regarding its value would increase and thus
intensifies the underpricing. (Beatty and Ritter, 1986) demonstrate that there
is a positive relation between the IPO underpricing and the uncertainty of
investors regarding its value because as the ex ante uncertainty regarding the
issue, making the winner’s curse problem intensifies.

A classification based on religious restrictions
creates market segmentation and has a great effect on IPO offer price and
subscription. In fact, this classification actively promotes Islamic firms and
makes them recognized by a greater number of investors than conventional
stocks. Therefore,
the classification is a way of promotion. (Habib and Ljungqvist , 2001) argue
that firms’ owners affect the level of underpricing through the choices they
make in promoting an issue, such as marketing expenditure. Therefore, there is
a trade-offs between promotion costs of going public and underpricing. A
testable implication of this model is that marketing expenditure increases with
the offering size and decreases underpricing.  Therefore, I hypothesize that Islamic firms
being more recognized by investors would have less IPO underpricing relative to
conventional firms.


(Ellul, Pagano, 2006) show that the less liquid the
aftermarket is expected to be, and the less predictable its liquidity, the
larger will be the IPO underpricing. They theorize a model that blends
liquidity concerns with adverse selection and risk and as motives for
underpricing. Using several measures of liquidity, they find that expected
after-market liquidity and liquidity risk are important determinants of IPO

It is well documented the relationship between returns and
liquidity with reference to seasoned securities. (Amihud and Mendelson, 1986)
among the first who argue that illiquid securities provide investors with a
higher expected return to compensate them for the larger trading costs they
have to bear. The argument
of SEO should be also applicable on the IPO offering.  If liquidity is priced on second market, it
is reasonable to expect stocks on the primary market to price liquidity. In
fact, the liquidity concern is more pronounced in the primary market and should
be priced more since it is a source of
uncertainty more than for seasoned securities. In fact, IPO investors do
not know yet how liquid the aftermarket will be and therefore will want to be
compensated also for this uncertainty.

Therefore, I hypnotize that Investor Recognition is
correlated with liquidity. Because Islamic firms are more recognizable among
investors, the liquidity risk factor is going to be reflected on the pricing as
a decrease in the return. On the other hand, investors knowing that
conventional firms are less recognizable and thus have a higher after-market
illiquidity would demand more ‘money be left on the table’ as a compensation of
the illiquidity risk. Therefore, I expect a positive correlation between IPO
underpricing and illiquidity. Also, I expect that conventional firms are on
average associated with higher after-market illiquidity.

Reasons to choose Saudi market:

I choose the stock market of Saudi Arabia to
test the effect of visibility on IPO pricing for several reasons. First, the
majority of traders in the Saudi stock market are individual traders, which
gives us the opportunity to test the effect of individual recognition on
trading behavior. Secondly, Saudi Arabia has a majority Muslim population, and
it is known for its strong adherence to Sharia law, which gives us the
opportunity to test the effect of religious beliefs on investor investment
decisions and portfolio construction. Third, in Saudi Arabia, clerics and
Islamic finance scholars voluntarily screen stocks and financial instruments
for their Sharia compliance and attempt to disseminate this information to the
public through different media channels. Therefore, using the sample of Saudi
stocks makes it possible to examine the impact of visibility on IPO pricing
proxied by Islamic-compliance firms.

As a proxy for investors’ recognition, I use
the classification list for Islamic or conventional firms published by Sharia
scholars. These classifications differ in the screening process and criteria
for selecting Islamic firms, but share some criteria, like the prohibition of
certain activities, such as  (1)
activities that involve in any form of usury or interest rates. (2) Activities
that involve excessive risk, uncertainty, ambiguity, or deception. (3)
Activities that are related by any means to gambling, lottery, or game of
chance. (4) Activities that are related to non-halal businesses, such as those
that deal with pork, adult entertainment, tobacco, non- medical alcohol, and
all other unethical businesses. In this paper, I rely on Dr. Al-Fozan’s stock
classification reports since it is commonly used by investors, covers stocks
listed in all sectors of equity market, and it is one of the strictest
classification as a base classification.

My sample consists of all firm-commitment
initial public offering from 2004 to 2017 in Saudi Arabia as reported by
Tadawel. I also obtain a complete list of IPO prospectus, which I use to get
the offering announcement dates, offering price, size of issue, and size of
firms. I also obtain the first day closing price for each firm using Tadawel
database. The sample consists of 110 observations.

Before examining the IPO underpricing of conventional
and Islamic stocks, I analyze the differences in IPO offering characteristics
between the two classes. Table 1 shows the summary statistics of firms during
the sample period, which spans from Jan 2004 to Dec 2017. Separating firms into
two groups, Islamic and conventional firms, based on Al-Fozan’s stock
classification shows that conventional firms tend to have a bigger firm size than
Islamic firms since the mean firm size of conventional firms is higher than
that of Islamic firms. However, Islamic firms have a higher offer size than the
conventional firms. There is no distinguishable difference in means between the
two classes.