Under Pricing and Long-term Performance of IPOs in China

8/6/2019 Under Pricing and Long-term Performance of IPOs in China

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Underpricing and long-term performance of

IPOs in China

Kalok Chana,*, Junbo Wangb, K.C. John Weia

a

Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay,Kowloon, Hong Kong, China

bDepartment of Finance, School of Management, Syracuse University, Syracuse, NY 13244, USA

Received 31 December 2001; received in revised form 28 January 2002; accepted 25 October 2002

Abstract

We study the underpricing and long-term performance of A- and B-share initial public offerings

(IPOs) issued in China during the 19931998 period. The average underpricing for A- and B share

IPOs are 178% and 11.6%, respectively. The underpricing of A-share IPOs is positively related to thenumber of days between the offering and the listing and the number of stock investors in the

province from which the IPO comes, and negatively related to the number of shares being issued.

None of these characteristics explain the underpricing of B-share IPOs. In the long run, A-share IPOs

slightly underperform the size- and/or book/market (B/M)-matched portfolios while B-shares

outperform the benchmark portfolios.

D 2003 Elsevier B.V. All rights reserved.

JEL classification: G30; G31

Keywords: IPO; China; Underpricing; Long-term performance

1. Introduction

This paper investigates the underpricing and long-term performance of initial public

offerings (IPOs) of common stocks in China. The purpose of this study is not limited to

adding another piece of evidence to the vast literature on IPO underpricing. Rather, we

would like to investigate how the underpricing of IPOs is affected by some institutional

factors in the centrally planned IPO market in China. In addition, we want to examine

whether the long-term IPO underperformance documented in the United States and other

developed markets also applies to a transition economy with central planning such as China.

0929-1199/$ - see front matterD 2003 Elsevier B.V. All rights reserved.

doi:10.1016/S0929-1199(03)00023-3

* Corresponding author. Tel.: +852-2358-7680; fax: +852-2358-1749.

E-mail address: [email protected] (K. Chan).

www.elsevier.com/locate/econbase

Journal of Corporate Finance 10 (2004) 409430


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IPO underpricingthe phenomenon of a large positive gain to a new issue (relative to

its offering price) immediately after listinghas been found in many markets. Loughran et

al. (1994) document evidence of IPO underpricing in 25 countries, with higher IPO

underpricing in developing than in developed markets.1 Compared with evidence fromother countries, the magnitude of underpricing in China is even more phenomena l. Mok

and Hui (1998) find that the underpricing of A shares in Shanghai was 289%. Su and

Fleisher (1999) show that the underpricing could exceed 948% if IPOs from earlier years

were included in the sample. Many different theories, such as information asymmetry and

signaling models, have been offered to explain the IPO underpricing phenomenon (Allen

and Faulhaber, 1989; Grinblatt and Hwang, 1989; Welch, 1989; Chemmanur, 1993).2

However, it is unlikely that these models can adequately explain underpricing of such a

magnitude as that happening in China.

An interesting characteristic of the Chinese IPO market is that the aggregate amount of

new shares issued each year is determined by the central government. Furthermore, the

new issues typically represent a small proportion of the outstanding shares, as the majority

of other shares are owned by the state or other legal entities and are not available to public

investors.3 As a result, the amount of new shares made available in the market is not

sufficient to satisfy the demand of Chinese investors who have very few alternative

investment choices. Another rigidity in the IPO market is that the offering price is

monitored by the China Securities Regulatory Commission (CSRC). In order to muster the

enthusiasm of the investors and to guarantee a full subscription, the offering price is set far

below what the market is willing to pay. As a result, this creates massive speculation on

IPOs when they are listed.Several researchers have investigated the IPO underpricing phenomenon in China. Mok

and Hui (1998) examine the pricing of IPOs in the early years of Chinas stock market

(before 1993), while Su and Fleisher (1999) focus on the signaling model to explain the

underpricing of IPOs in China. In this paper, we examine the performance of the IPOs

using a more recent sub-period (A-share IPOs from 1993 to 1998 and B-share IPOs from

1995 to 1998). Another contribution is that we examine what institutional factors can

explain differences in IPO underpricing across different stocks. Consistent with previous

studies, we find that there are large abnormal returns (178%) to the A-share IPOs on the

first trading day. The underpricing is mainly driven by the institutional setups in China,

which price IPO shares substantially below their non-IPO counterparts, especially for Ashares, based on firms fundamentals such as price/earnings (P/E) ratios and the book/

market (B/M) ratios. We show that the cross-sectional variations of abnormal returns can

be explained by some institutional characteristics, including the percentage of equity

retained by the state and legal entities, the time lag between offering and listing, and the

stage of development of the province from which the IPO firm comes, which is proxied by

the number of stock investors in that province. As for B shares, since foreign investors

1 Please visit Jay Ritters website at http://bear.cba.ufl.edu/ritter/interntl.htm for the most recent updated

information.2 There are some theories to explain the IPO underpricing that focuses on the role of underwriters in resolving

the asymmetric information. See, for example, Sherman (2000) and Sherman and Titman (2002), among others.3 The shares owned by the state or legal entities cannot be traded in the stock exchanges.

K. Chan et al. / Journal of Corporate Finance 10 (2004) 409430410
http://%20http//www.bear.cba.ufl.edu/ritter/interntl.htmhttp://%20http//www.bear.cba.ufl.edu/ritter/interntl.htm


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have a large investment opportunity set outside China, there is less speculation on B-share

Chinese IPOs, and the average return of the IPOs on the first day of trading is only 11.6%.

Furthermore, the underpricing of the B-share IPOs cannot be explained by institutional

characteristics.We also investigate the long-term performance of the IPOs after the listing. Despite the

fact that the initial IPO returns for A shares are abnormally high, we find that the long-term

under performance for A shares is only moderate as compared with the IPOs in the U.S.

(i.e., Loughran and Ritter, 1995; Ritter, 1991) and other developed markets (i.e., Levis,

1993; Cai and Wei, 1997).4 Therefore, the abnormally high returns for the A-share IPOs

on the initial day are due to heavy underpricing rather than to excessive optimism on pure

speculation. On the other hand, B-share IPOs significantly outperform their benchmarks.

Based on a 1- to 3-year window, A-share IPOs underperform all benchmarks slightly with

the wealth relatives ranging from 0.90 to 0.98. In addition, the long-run stock price

performance is partially related to operating performance. On the other hand, B-share IPOs

outperform all benchmarks with the wealth relatives ranging from 1.105 to 1.453.

The remainder of this paper is organized as follows. Section 2 discusses the institutional

characteristics of the Chinese IPO market. Section 3 presents the data and preliminary

analysis. Section 4 provides evidence on the determinants of cross-sectional variations of

underpricing, while Section 5 shows the results on long-term performance of IPOs.

Section 6 reports the results on the operating performance for A-share IPO firms

surrounding the offering year. Finally, Section 7 concludes the paper.

2. Characteristics of the Chinese IPO market

Following the economic reforms that began in 1978, the Chinese stock market was

finally established in the early 1990s. The Shanghai Securities Exchange was opened in

1990, followed by the establishment of the Shenzhen Stock Exchange in 1991. At the

same time, the Chinese stock market was made partially accessible to foreign investors.

Non-PRC nationals could trade B shares listed on the two stock exchanges in Shanghai

and Shenzhen, H shares listed on the Stock Exchange of Hong Kong, and N shares listed

on the New York Stock Exchange.

There are five types of shares in China: (1) government shares, which are held by theState Assets Management Bureau (SAMB); (2) legal entity shares (or C shares), which are

held by other state-owned enterprises; (3) employee shares, which are held by managers

and employees; (4) ordinary domestic individual shares (or A shares), which can be

purchased only by Chinese citizens of the PRC on the Shanghai Securities or the Shenzhen

Stock Exchange; and (5) foreign shares, which can be purchased only by foreign investors

in Mainland China (B share), in Hong Kong (H share), or on the NYSE (N share). Only A

shares and B shares are listed on the Shanghai Securities and Shenzhen Stock Exchanges.

The first three types of shares are not tradable in the official exchanges, although employee

shares are allowed to be listed 3 years after the IPO.

4 However, Megginson et al. (2000) find long-run return outperformance for share issue privatizations from

33 countries. See Megginson and Netter (2001) for an excellent review of this literature.

K. Chan et al. / Journal of Corporate Finance 10 (2004) 409430 411


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The initial public offering process in China has vestiges of Chinas transitional economy

with socialist planning. First, the aggregate value of new shares to be issued each year is

part of the national investment and credit plan. The new share issue quota is determined

jointly by the State Council Securities Committee (SCSC), the State Planning Commission(SPC), and the Peoples Bank of China (PBOC) (which is the central bank in China). The

quota is allocated to provinces as well as to municipalities. The criteria used for allocation

among provinces include the assessment of regional needs based on the production

structure and industrial base and recognition of balanced regional development to attain

distribution objectives. Within each regional quota, the local securities authorities invite

enterprises to request a listing and then make a selection based on the criteria that combines

good performance as well as sectional development objectives. This process of selecting

enterprises for listing in China differs considerably from a more mature market economy,

where the decision to list an enterprise is usually determined by the stock exchange.

Because the aggregate supply of new shares is controlled by the central government,

the supply fails to meet the demand of public investors who generally lack alternative

investment choices. This is because the financial markets remain poorly developed and

Chinese capital controls make it difficult to invest overseas. As a result, this creates huge

speculation on the IPOs as public investors invariably rush to submit applications

whenever there are new issues. The speculation is further fueled by the inefficiency of

the offering price determination process, which is monitored by the CSRC. In order to

rouse the enthusiasm among investors and to guarantee a full subscription, the offering

price is set far below what the market would be willing to pay. From 1993 to 1998, the

IPOs in China essentially adopted an administrative pricing policy. During this time, theIPO price was set around 15 times of the earnings per share and in the range of 1316

times.5 Furthermore, the offering price was chosen months before the official trading

began and, for a great majority of offerings, there was no feedback mechanism that

allowed the market demand to influence the final offering price.

Another factor contributing to the speculation on IPOs is the method of share

allocation. At the beginning, the share allocation was based primarily on a lottery system

in which there was a fixed number of application forms. Each retail investor was allowed

to purchase a limited number of lottery forms, and lottery winners were entitled to a certain

number of shares per winning form. The lottery mechanism has undergone several changes

subsequently. One modification is to allow an unlimited number of application forms, so

5 However, there is no official regulation about what the exact P/Eratio is used for pricing IPOs. In addition,

the detailed IPO pricing policies have been changed several times in the past. Before 1996, IPO pricing was based

on the forecasted P/E ratio. The CSRCs December 26, 1996 notice changed IPO pricing to be based on the

realized arithmetic average P/Eratio in the past 3 years. The CSRCs September 10, 1997 notice modified the IPO

pricing formula to: IPO price = EPS*P/E, where EPS = 0.7*EPS in the year before the IPO + 0.3*Forecasted

diluted EPS during the IPO year, and the P/E should be within the maximum and minimum allowed P/Es with a

very complicated formula. The CSRCs March 17, 1998 notice changed the IPO pricing formula to: IPO

price=(Forecasted Earnings/Weighted Average Number of Shares Outstanding in the IPO year)*P/E. The CSRCs

July 28, 1999 notice began to allow issuers and underwriters to set an initial offering price range subject to the

approval from the CSRC. The final offering price must fall in the price range approved by the CSRC. If the final

offering price is outside the price range, it needs to be re-approved by the CSRC. Recently, the CSRC issued a

consultancy paper to solicit public opinions on how to use the online auction method to price IPOs.



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that investors can buy as many application forms as they would like. Another modification

is to require the investors to deposit a certain amount of money into a special savings

account when submitting applications for shares, with the deposit frozen until the lottery

was completed. Despite these changes, there is no feedback from market demand in settingthe offering price. Although an auction mechanism was introduced in recent years, the

price was fixed to a certain extent and investors could only bid on the quantity of shares

they would buy, not on the price of the shares.

Another characteristic of the Chinese IPO market is that new issues reflect only a small

proportion of outstanding shares. The majority of shares are still owned by the government

or other legal entities. The retention of equity by the government has two opposing

implications for IPO underpricing. When the state retains a high percentage of shares so

that only a small percentage of shares are available to public investors, there could be more

speculation so that returns on the first day of trading would be higher. On the other hand, a

high percentage of shares being retained by the state may be equated with inefficiency and

low productivity, leading to fewer investors buying the new shares on the first day of

trading, so the initial return would be lower.

3. Data and summary statistics

Our data are retrieved from the Taiwan Economic Journal (TEJ) database. The sample

period for A-share IPOs is from January 1993 to December 1998. As for B shares,

although the first B-share IPO was in February 1992, it was not until 1995 that more newissues were regularly introduced into the market. Consequently, we study the B-share IPOs

only from January 1995 to December 1998. As we mentioned earlier, there is a long time

lag between the offering date and the listing date. We exclude those new issues that have

elapsed time between these dates longer than 360 days. The final sample includes 570 A-

share IPOs and 39 B-share IPOs.

The underpricing of an IPO issue is calculated as the return on the first day of trading

(relative to the offering price):

Ret0 1

nX

n

i1

Pi0

Pil 1 1

where Ret0 is the average return (underpricing) of the IPOs on the first trading day (day 0),

Pi0 is the closing price of stock i on day 0, and Pil is the offering price of stock i. We also

adjust the return for the market effect:

Adjret0 1

n

Xni1

Pi0

Pil

Pi;m0

Pi;ml

2

where Adjret0 is the average of the market-adjusted returns (including dividends) of IPOson day 0, Pi,m0 is the closing value of the corresponding Shanghai or Shenzhen A-share or

B-share market index on the first trading day of the new issue i, Pi,ml is the closing value of



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the corresponding Shanghai or Shenzhen A-share or B-share market index on the offering

day of the new issue i.

We will include several variables to explain cross-sectional variations of underpricing.

The first variable is the number of days between offering and listing (Lday). Unlike indeveloped markets where only a short time elapses between the offering and the listing, it

is typical in China for the new issues to be offered for public subscription more then 2

months before their listing on the stock exchanges. Due to the asymmetric information

distribution among the issuer, underwriters and investors (Baron, 1982; Rock, 1986) and

to the fact that funds will be tied up, the longer time gap between the offering and the

listing will increase the risk to investors so that a larger underpricing is required.

Therefore, we expect a positive relation between Lday and underpricing.

The second variable is the number of shares being issued (Lnum). There is extensive

evidence that suggests that the demand curve for shares in an individual company is not

perfectly elastic (Shleifer, 1986 and others). When there are more shares being issued,

investors do not need to buy the shares urgently on the first day of trading so that initial

returns will be lower. Thus, a negative relationship between Lnum and underpricing is

predicted.

The third variable is the number of stock investors in the area (province or municipal-

ity) during the year when the IPO is issued (Investor). Since the listing criteria is not solely

based on the quality of the companies, but is also determined by the central government

that tries to balance the development of different provinces, not all IPOs are of similar

quality. We conjecture that the IPOs from the more developed provinces are of higher

quality than those from less developed ones. The number of stock investors in the provinceis used as a proxy for the stage of development (wealth) of the area. The correlation

between Investor and underpricing is expected to be positive.

The fourth variable is the percentage of the non-negotiable state and institution

shares (Percent). When the state or legal entities retain a high percentage of shares, this

might be perceived as an indicator of bureaucratic control and operating inefficiency.

Therefore, fewer investors would be willing to pay a higher price. We conjecture that there

is a negative relationship between Percent and the underpricing.

Table 1 presents the unadjusted and the market-adjusted underpricing for A-share and

B-share IPOs. Panel A contains the results for the whole sample period from 19931998

as well as for each year. The average underpricing for A-share IPOs was 177.8% for thewhole period, while that for B-share IPOs was only 11.6%. The underpricing for both A-

share and B-share IPOs was only slightly lower, when the initial returns were adjusted for

market movements. A breakdown of the IPOs by year shows that the underpricing of A

shares was quite persistent. Except for 1995 when there were only four IPOs, the

underpricing was greater than 100% in all years studied.

Since the CSRC began to allow issuers and underwriters to set an initial offering price

range subject to the approval from the CSRC, instead of a fixed pricing formula starting

July 1999, it would be interesting to briefly discuss whether the short-term underpricing in

the post-1999 period is different from the underpricing in the pre-1999 period.6 There are a

6 The 19992001 sample is only used to examine the short-term underpricing. It is too short to investigate

the long-term performance.



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total of 286 A-share IPOs from 1999 to 2001, and only 7 B-share IPOs from 1999 and 2000.

There are no B-share IPOs in 2001. This was due to a policy change in China in 2001. To

pave the road for B shares to gradually converge to A shares, in February 2001, the CSRC

announced that the PRC citizens whoever have the foreign currencies could start to trade B

shares and that the B-share IPOs market would be suspended. The result reported in Panel B

of Table 1 indicates that the average underpricing for A-share IPOs during the period 1999

2001 was 107.5% (the average market-adjusted initial return = 105.7%), which is much

lower than the underpricing in the earlier years but it is still very high. The year-by-year

result shows that, except for the most recent year 2001, the underpricing for A-share IPOswas more than 110%. However, the underpricing for A-share IPOs has reduced substan-

tially to less than 20% in the year 2001. Whether this is due to the effectiveness of the

Table 1

Underpricing of the IPOs in China from 1993 to 2001

Year A share B share

Unadjusted Adjusted N Unadjusted Adjusted N

Ret t-Value Ret t-Value Ret t-Value Ret t-Value

Panel A. Underpricing for A-share and B-share IPOs: 19931998

1993 3.378*** 11.78 3.289*** 11.75 120

1994 1.266*** 10.36 1.379*** 10.93 70

1995 0.140* 1.90 0.168* 1.83 4 0.053* 1.72 0.063** 2.04 9

1996 1.167*** 18.75 1.103*** 17.89 144 0.060*** 2.60 0.025 0.74 13

1997 1.495*** 26.64 1.497*** 27.27 186 0.240*** 3.39 0.297*** 4.14 14

1998 1.375*** 11.14 1.335*** 10.81 46 0.03 0.72 0.030 0.52 3Avg 1.778*** 23.00 1.754*** 23.23 570 0.116*** 3.74 0.132*** 3.78 39

Panel B. Underpricing for A-share and B-share IPOs: 19992001

1999 1.130*** 14.15 1.098*** 14.31 81 0.293 0.322 1

2000 1.509*** 20.16 1.484*** 20.00 135 0.332*** 9.11 0.395*** 11.16 6

2001 0.173** 2.33 0.144* 1.92 70

Avg 1.075*** 19.33 1.047*** 18.98 286 0.326*** 10.43 0.385*** 12.14 7

This table reports the unadjusted and adjusted initial returns of A-share and B-share IPOs in China. Panel A

reports the sample that includes 570 A-share IPOs between January 1993 and December 1998 and 39 B-share

IPOs between January 1995 and December 1998, while Panel B reports the sample from 1999 to 2001. The

unadjusted and adjusted initial returns of the IPOs are defined as

Ret0 1

n Xn

i1

Pi0

Pil 1

and

Adjret0 1

n

Xni1

Pi0

Pil

Pi;m0

Pi;ml

;

respectively. Pil is the closing price of stock i on the first trading day, Pi0 is the offering price of stock i, Pml is the

closing price of the appropriate Shanghai or Shenzhen A-share or B-share market index on the first trading day of

the new issue i, Pm0 is the closing price of the appropriate Shanghai or Shenzhen A-share or B-share market index

corresponding to the offering day of the new issue i.

* Significant at the 10% level.

** Significant at the 5% level.

*** Significant at the 1% level.



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Table 3

Regression results for the underpricing of IPOs in China from 1993 to 1998

Intercept Lday Lnum Percent Investors Age Exch Mktret

Panel A: Regression results for the underpricing of A-share IPOs (N = 570)

Coeff 4.835*** 0.661*** 0.348*** 0.013** 0.116* 0.006* 0.031 1.618*t-Value (4.56) (7.71) ( 4.14) ( 2.13) (1.87) ( 1.72) (0.23) (5.78)

Panel B: Regression results for the underpricing of B-share IPOs (N = 39)

Coeff 0.096 0.009 0.003 0.001 0.001 0.003* 0.069 0.028 t-Value (0.09) ( 0.15) ( 0.04) ( 0.18) ( 0.03) (1.68) (0.98) (0.07)

Panel A reports the underpricing regression for A-share IPOs and Panel B for B-share IPOs.

Lday is the number of days between the offering and listing dates, Lnum is the number of shares issued, Percent is the pe

institution shares, Investors is the number of investors in the region from which the IPO comes, Age is the number of years th

Exch is a dummy variable which is equal to 1 if the new issue is listed on the Shenzhen Stock Exchange and 0 if it is listed on t

the return on the corresponding stock market index between the offering and listing dates, Issp is the issue price, and Offshore

new issue has issued any offshore shares and 0 otherwise. t-Values are in parentheses.

* Significant at the 10% levels.




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Exchange, the issue price (Issp), the age of the company (Age), and a dummy variable

(Offshore) that is equal to one if the company issues some kind of offshore shares, such as

H shares in Hong Kong or N shares in New York, and zero otherwise.

The regression results are reported in Table 3. Panel A contains the results for A-shareIPOs. In the multivariate regression, the underpricing of A-share IPOs is positively and

significantly related to the number of days between offering and listing (Lday), and the

number of stock investors in the area in the year when the IPO is issued (Investor); and

negatively and significantly related to the number of shares being issued (Lnum) and the

percentage of the non-negotiable state and institution shares (Percent).7 Panel B

contains the results for B-share IPOs. Unlike that of the A-share IPOs, the underpricing

of B-share IPOs cannot be explained by any of the four institutional variables. In fact, none

of the control variables explains the variations in the underpricing. Therefore, the

underpricing of B-share IPOs is quite different from that of A-share IPOs. First, the

magnitude of underpricing of B shares, as documented in Table 1, is much smaller.

Second, there is no systematic force that explains the underpricing of B shares.

5. Long-term performance

5.1. The stock price long-term performance

Given that the exceptionally high returns for A-share IPOs on the first day of trading, an

interesting question is whether such underpricing, maybe due to investors overreaction,will be corrected by stock price performance in the long run. For example, Ritter (1991)

and Loughran and Ritter (1995) found that IPOs in the U.S. underperform significantly

relative to non-issuing firms for 3 to 5 years after the listing date. Many studies also

provide international evidence on the long-run underperformance of IPOs that is consistent

with what has been observed in the U.S. market.8 However, Megginson et al. (2000)

examine the long-run (1 to 5 years) performance of 158 share issue privatizations from 33

countries (including Chinese state-owned enterprises that list their shares on the Hong

Kong Exchange) during the period 19811997 and find statistically significant positive

net returns for all holding periods as compared to a variety of benchmarks.

We therefore follow the performance of the IPOs in the 36 months after listing.9

Insteadof using the calendar month, we follow Ritter (1991) and assume that there are 21 trading

days in 1 month. Therefore, the first month consists of the first 21 trading days after the

first day (denoted as day 0) listing, the second month consists of day 22 through day 42

after listing, and so on.

Previous studies suggest that the measure of long-run performance for IPOs is sensitive

to the benchmark used. Furthermore, Barber and Lyon (1997) show that when long-run,

7 The results from the univariate regressions (not reported here) are consistent with those from the

multivariate regression, except for Percent, which is positively related to the underpricing.8 For example, see Levis (1993) for the U.K. market and Cai and Wei (1997) for the Japanese market.9 Since the history of the stock market in China is short, unlike in Ritter (1991), Loughran and Ritter (1995),

and Megginson et al. (2000), we only follow the IPO performance for 3 years after the issues.



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buy-and-hold abnormal returns are calculated using a reference portfolio, the test statistics

are negatively biased. This bias is, however, not present when abnormal returns are

calculated as the return of a sample firm less the return of a single control firm matched on

size or book/market ratio.10 As a result, we follow Ritters (1991) procedure to constructthree benchmarks to measure the adjusted performance of the IPO firms: the size-matched,

the B/M-matched, and the size-and-B/M-matched non-IPO portfolios. The size and book-

to-market characteristics have been documented extensively as important determinants of

stock returns (Banz, 1981; Chan et al., 1991; Daniel and Titman, 1997; Daniel et al., 2001;

Fama and French, 1992; Davis et al., 2000; Davis, 1994; Lakonishok et al., 1994;

Loughran and Ritter, 1995).

For the size-matched portfolio, each IPO firm is matched with a firm that has been

listed for at least 2 years and has the closest market value at the end of the issuing calendar

month.11 The procedure for matching by B/M is the same except that the book value for

the issuing firm also includes the issuing proceeds.12 To control for both size and B/M

effects, a non-IPO firm in the previous 2 years is chosen such that the absolute percentage

difference between size and B/M is minimal. Since there are two types of shares for every

listed company in China: tradable and nontradable, we will use both measures to compute

the market value. Specifically, when total shares are used, the market value (more

precisely, the total market equity) is defined as the number of total shares outstanding

multiplied by the stock price at the end of the issuing month, and B/M is defined as the

previous years book equity divided by the total market equity. Similarly, when the traded

shares are used, the market value (more precisely, tradable market equity) is defined as the

number of tradable shares multiplied by the stock price at the end of the issuing month,and the B/M is defined as the previous years book equity multiplied by the ratio of

tradable shares to total shares and then divided by tradable market equity. However, the

results are essentially the same for both measures of market value. To save space, in the

following, we only report the results based on the tradable shares.

Barber and Lyon (1997), Conrad and Kaul (1993), and Kothari and Warner (1997)

demonstrate that there are potential biases from summing up average benchmark-adjusted

returns over long horizon. Therefore, we focus on the holding period return and the wealth

relative as suggested by Ritter (1991) and Loughran and Ritter (1995) as the performance

measure:

Wealth relative 1 average T period total return on IPOs

1 average T period total return on matching firms3

By definition, a wealth relative of greater than 1.00 can be interpreted as IPOs out-

performing a portfolio of matching firms. Similarly, a wealth relative of less than 1.00

suggests that IPOs underperform a portfolio of matching firms.

10 This idea of matching firms was first suggested by Ritter (1991) and followed by Loughran and Ritter

(1995) and others.11 Since the history of the stock market in China is only slightly over 10 years, unlike in Ritter (1991), we

choose 2 years instead of 3 years to identify our non-IPO matching firms.12 We use the market value at the end of the issuing calendar month.



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Table 4

The long-term performance of the IPOs in China

Months N CRet Size-matched B/M-matched Size-and-B/M-matched

CBenret Wealthrelative



Panel A. A-share IPOs

1 570 1.690 5.170 0.967 6.042 0.959 6.970 0.951

2 570 1.251 4.846 0.942 4.021 0.949 5.275 0.9383 570 0.879 4.902 0.945 2.665 0.965 4.209 0.9514 570 2.910 8.718 0.947 6.496 0.966 7.308 0.959

5 570 4.135 7.927 0.965 6.322 0.979 6.936 0.974

6 570 5.745 8.553 0.974 6.373 0.994 5.884 0.999

7 570 8.024 11.250 0.971 9.217 0.989 8.388 0.997

8 570 8.989 11.093 0.981 10.675 0.985 10.242 0.989

9 570 10.467 13.000 0.978 11.648 0.989 11.126 0.99410 570 12.079 16.507 0.962 14.637 0.978 13.814 0.985

11 570 13.814 17.559 0.968 15.312 0.987 14.915 0.990

12 570 11.551 15.280 0.968 14.526 0.974 13.471 0.983

13 570 11.357 16.772 0.954 16.188 0.958 15.074 0.968

14 570 11.231 17.538 0.946 16.711 0.953 15.816 0.960

15 570 12.582 19.380 0.943 17.885 0.955 16.514 0.966

16 570 15.196 20.399 0.957 20.595 0.955 18.226 0.974

17 570 16.874 20.473 0.970 21.320 0.963 20.277 0.972

18 570 18.139 22.092 0.968 23.080 0.960 20.984 0.976

19 558 21.055 22.956 0.985 25.736 0.963 21.680 0.995

20 548 25.689 29.654 0.969 29.450 0.971 26.450 0.994

21 540 27.782 33.359 0.958 30.278 0.981 29.440 0.98722 537 27.482 32.416 0.963 29.807 0.982 29.296 0.986

23 526 29.453 34.293 0.964 31.022 0.988 30.661 0.991

24 522 30.657 34.963 0.968 32.698 0.985 33.697 0.977

25 514 29.548 34.011 0.967 32.812 0.975 32.129 0.980

26 506 32.640 37.070 0.968 35.739 0.977 35.942 0.976

27 497 33.294 38.412 0.963 38.633 0.961 38.443 0.963

28 492 34.253 39.667 0.961 40.709 0.954 38.905 0.967

29 481 39.622 45.831 0.957 44.687 0.965 43.298 0.974

30 435 43.512 49.447 0.960 49.571 0.959 48.697 0.965

31 401 46.611 56.046 0.940 56.581 0.936 54.408 0.950

32 374 53.039 64.386 0.931 59.058 0.962 60.517 0.953

33 366 60.606 70.637 0.941 65.210 0.972 69.952 0.945

34 353 66.599 72.919 0.963 71.566 0.971 76.606 0.943

35 337 71.238 81.040 0.946 73.826 0.985 87.181 0.915

36 319 75.067 89.505 0.924 78.631 0.980 94.837 0.899

Panel B. B-share IPOs

1 39 14.443 2.562 1.116 2.688 1.114 7.074 1.069

2 39 15.609 0.207 1.154 1.480 1.173 5.375 1.0973 39 13.490 3.305 1.099 3.318 1.174 6.304 1.068

4 39 15.386 5.868 1.090 2.285 1.181 8.537 1.0635 39 26.155 5.867 1.192 2.126 1.235 12.845 1.118

6 39 27.431 0.957 1.262 1.365 1.257 10.982 1.1487 39 27.375 1.561 1.254 3.512 1.231 13.750 1.120

8 39 37.314 5.833 1.297 7.560 1.277 19.506 1.149



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suggest that A-share IPOs in China underperform the corresponding benchmarks. How-

ever, the underperformance is modest compared with the IPOs in the U.S. and Japan.

Loughran and Ritter (1995) find that the three-year wealth relative for U.S. IPOs is 0.80

when IPO firms are matched with non-IPO firms by size. Cai and Wei (1997) find that the

3-year wealth relative for Japanese IPOs ranges from 0.67 to 0.77 when IPO firms arematched by size, B/M, or both size and B/M. Results for B-share IPOs are shown in Panel

B of Table 4 and plotted in Fig. 2. In contrast to the result for A shares, B-share IPOs

Fig. 1. A-shares monthly cumulative return.

Fig. 2. B-shares monthly cumulative return.



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outperform the market as the wealth relatives are always greater than 1.00 during these 36

months after listing. At the end of month 36, the wealth relatives against different

benchmarks range from 1.28 to 1.36.

Panel A of Table 5 reports the buy-and-hold return for different periods of A-share IPOsand their matching firms. Although the IPOs underperform their matching firms for all

Table 5

Average percentage returns during the 3 years after issuing for A- and B-share IPO firms, and their matching firms

First 6 months First year First 2 years First 3 years

Return t-Value Return t-Value Return t-Value Return t-Value

Panel A. A-share IPO firms and their matching firms

A1. Based on size-matched portfolios

IPO firms (%) 5.74*** 2.90 11.55*** 4.41 30.66*** 7.72 75.07*** 9.52

Matching firms (%) 8.55*** 4.35 15.28*** 5.76 34.96*** 8.93 89.51*** 9.72

Difference 2.82 1.22 3.75 1.20 4.30 0.93 14.44 1.32Sample size 570 570 522 319

A2. Based on B/M-matched portfolios

IPO firms (%) 5.74*** 2.90 11.55*** 4.41 30.66*** 7.72 75.07*** 9.52

Matching firms (%) 6.37*** 3.42 14.53*** 5.88 32.70*** 8.05 78.63*** 9.42

Difference 0.63 0.27 2.97 1.48 2.04 0.45 3.56 0.36Sample size 570 570 522 319

A3. Based on size-and-B/M-matched portfolios

IPO firms (%) 5.74*** 2.90 11.55*** 4.41 30.66*** 7.72 75.07*** 9.52

Matching firms (%) 5.88*** 3.19 13.47*** 4.93 33.70*** 7.60 94.84*** 9.25

Difference 0.14 0.02 1.92 0.69 3.03 0.01 19.77* 1.74Sample size 570 570 522 319

Panel B: B-share IPO firms and their matching firms

B1. Based on size-matched portfolios

IPO firms (%) 27.43** 2.54 43.54** 2.18 16.75 0.81 13.88 0.72

Matching firms (%) 0.96 0.14 1.23 0.12 10.56 0.72 16.17 1.46

Difference 26.47*** 3.58 44.77*** 2.77 27.31 1.14 30.04 1.19

Sample size 39 39 36 22

B2. Based on B/M-matched portfolios

IPO firms (%) 27.43** 2.54 43.54** 2.18 16.75 0.81 13.88 0.72

Matching firms (%) 1.36 0.20 14.76 1.19 2.59 0.18 12.71 1.22

Difference 26.07*** 4.48 28.78** 2.25 14.16 0.60 26.58 1.09Sample size 39 39 36 22

B3. Based on size-and-B/M-matched portfolios

IPO firms (%) 27.43** 2.54 43.54** 2.18 16.75 0.81 13.88 0.72

Matching firms (%) 10.98 1.43 13.71 1.24 5.62 0.35 11.19 1.02Difference 16.45** 2.47 29.83* 1.93 11.12 0.44 25.06 0.98

Sample size 39 39 36 22

This table reports the average holding period returns for IPO firms and their matching firms after the first trading

day based on three benchmarks: the size-matched, the B/M-matched, and the size-and-B/M-matched bench-

marks. The tradable shares are used to compute the market values. The detailed matching procedure is described

in Table 4.

Panel A reports the results for A shares, and Panel B for B shares.






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growth rate (CE). We also calculate industry-adjusted changes in operating performance,

which is defined as the deviation of a given firm from the industry median.

Results indicate that ROA, CFOA, and ATO decline significantly after the issuance,

regardless of which event window we use. For example, if we measure changes in

performance from year t 1 to year t+ 1, ROA declines by 7.57%, CFOA by 7.30%,and ATO by 37%. On an industry-adjusted basis, the changes in operating performance

remain statistically significant. These results are consistent with Jain and Kini (1994) and

Mikkelson et al. (1997) who find that IPO firms in the U.S. exhibit a decline in their post-

issuance operating performance. However, in a survey paper on the privatization of state-owned enterprises (SOEs), Megginson and Netter (2001) document that privatized firms

become more efficient, more profitable, and financially healthier, and reward investors.

Table 7

Changes in operating performance of IPO firms surrounding the issuing year

Measure of operating performance Year relative to the IPO year

From 1 to 0 From 1 to 1 From 1 to 2 From 1 to 3

Panel A. Operating return on assets (ROA)

Mean change (%) 4.79*** 7.57*** 9.71*** 9.22***Mean industry-adjusted change (%) 3.58*** 4.50*** 5.12*** 3.58*** Number of observations 254 253 212 85

Panel B. Operating cash flows/total assets (CFOA)


Panel C. Sales growth rate (Sale_G)Mean change (%) 19.57*** 51.96*** 90.08*** 169.06***

Mean industry-adjusted change (%) 12.75*** 40.53*** 74.46*** 152.34***

Number of observations 343 342 299 132

Panel D. Asset turnover (ATO)


Panel E. Capital expenditures growth rate (CE)

Mean change (%) 146.88*** 250.99*** 253.90*** 37.29

Mean industry-adjusted change (%) 136.44*** 233.01** 243.47*** 92.87*** Number of observations 248 248 248 207

This table presents the mean change/growth in operating performance of IPO firms during the period of 1993

1998.

ROA is return on assets and is measured as the operating income before depreciation and amortization as a

percentage of total assets. CFOA is the operating cash flow on assets and is defined as the operating income less

capital expenditures. Sale_G is the growth rate of net sales. ATO is the asset turnover measured as net sales over

total assets. CE is measured as the growth rate of capital expenditures compared with the year prior to IPOs. The

industry-adjusted change/growth for a given firm is the deviation from the industry median. Year 0 is the fiscal

year during which the firm goes public.





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We also find that both the sales growth rate and the capital expenditure growth rate of

IPO firms exhibit substantial increases relative to the industry. Therefore, the inferior

operating performance in ROA, CFOA, and ATO is not related to a decline in business

activity. Rather, these results are consistent with the hypothesis that managers attempt to

window-dress their accounting reports prior to going public, which leads to pre-IPO

performance being over-stated and post-IPO performance being understated.15

6.2. The relationship between operating performance and stock performance

Table 8 reports the results of cross-sectional regressions of post-issuance stock returns

on operating performance. The 1-year and 2-year abnormal returns are positively related to

DROA, DCFOA, and DSale_G. Therefore, although mangers tend to manipulate account-

ing reports before the IPOs, the information on the changes in operating performance is

Table 8

Cross-sectional regressions of post-issuing stock returns on operating performance

Variable Intercept DROA DCFOA DSale_G DATO DCE R2

Panel A. Regression results for 1-year accumulative abnormal returns (N = 248)Coeff. 9.648*** 0.602* 0.340*** 0.073 0.005 0.157t-Value ( 3.113) (1.908) (5.478) ( 1.274) ( 0.456)Coeff. 9.934*** 0.702** 0.340*** 0.082 0.004 0.159t-Value ( 3.244) (1.992) (5.472) ( 1.402) ( 0.345)

Panel B. Regression results for 2-year accumulative abnormal returns (N = 212)

Coeff. 8.261** 1.354*** 0.094*** 0.046 0.009* 0.199t-Value ( 2.117) (4.138) (2.806) ( 0.707) (1.786)Coeff. 9.376** 1.465*** 0.095*** 0.056 0.010* 0.201t-Value ( 2.470) (4.195) (2.862) ( 0.867) (1.920)

Panel C: Regression results for 3-year accumulative abnormal returns (N = 85)

Coeff. 22.187*** 0.168 0.153*** 0.082 0.022 0.230t-Value ( 3.555) (0.251) (3.441) ( 0.901) (1.485)

Coeff. 21.728*** 0.379 0.152*** 0.091 0.022 0.233t-Value ( 3.462) (0.537) (3.420) ( 0.992) (1.481)

This table reports the regression results of the post-issuing stock price performance on the post-issuing operating

performance.

The dependent variable is the 1-, 2-, and 3-year stock abnormal returns following the IPOs. The independent

variables are changes in industry-adjusted operating performance measures. ROA is return on assets and is

measured as the operating income before depreciation and amortization as a percentage of total assets. CFOA is

the operating cash flow on assets and is defined as the operating income less capital expenditures. Sale_G is the

growth rate of net sales. ATO is the asset turnover that is measured as net sales over total assets. CE is measuredas the growth rate of capital expenditures compared with the year prior to IPOs. The industry-adjusted change/

growth for a given firm is the deviation from the industry median.




15 See Aharony et al. (2000) for the evidence of earnings manipulations of H shares and B shares before their

IPOs.



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Acknowledgements

The authors would like to thank Jeffrey M. Netter (the editor) and an anonymous

referee for insightful comments and Dr. Virginia Unkefer and Joanne Zhong for theeditorial assistance. We also acknowledge the Earmarked Research Grant of the Research

Grants Council of the Hong Kong Special Administration Region, China (HKUST601/

96H) for financial support.

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Documents

Under Pricing and Long-term Performance of IPOs in China