Blog : The IPO Pump

by Ed Zwirn on April 12th, 2013

By Ed Zwirn

Have you ever bought into the initial public offering of a penny stock impressed by its initial trading gain but underwhelmed by the stock's performance after day one? IPOs of penny stocks show "significantly higher initial returns" than those of IPOs in higher-priced companies but tend to underperform them over a longer period of time, according to research slated to appear in an upcoming issue of Financial Management.

Daniel Bradley of the University of South Florida, John Cooney Jr. of Texas Tech, Steven Dolvin of Butler University and the University of Kentucky's Bradford Jordan looked at nearly 3,000 IPOs from the 1990s and early 2000s and found that penny stock IPOs saw much greater price spikes in their first day of trading.

Of the 2,958 stocks in the sample, the penny stocks were found to gain an overall 22.4% on their debut day, while other IPOs were found to gain 15.4%.

Of course, market manipulation may have contributed to some of this success. To account for this, the researchers cross checked their data against a list of 39 underwriters that had been the subject of SEC action over the period. What they found is that the penny stocks underwritten by these entities had a much higher (31.6%) first-day return than the supposedly cleaner others (19.2%). The non-penny stock IPOs saw stocks underwritten by "clean" underwriters score slightly better than those facing SEC action.

According to the authors, the sharp prices rises for penny stock IPOs led by the 39 underwriters can serve as evidence that they are "significantly more underpriced" than the others on the list. Also, the evidence suggests, these initially high flying penny stocks tend to perform worse in the long run.

"This pattern of high initial returns, followed by especially poor long-run performance for the penny stock issues led by these underwriters, suggests that market manipulation and/or fraud may explain a substantial part of the underpricing and long-run underperformance of penny stock IPOs," they write.

On the other hand, penny stock IPOs not led by one of these "sanctioned" underwriters have higher three- and five-year market-adjusted buy-and-hold returns.

Pump-and-dump stock plays have long been a fixture of the penny stock IPO market and for one very good reason: They work, at least over the timeframe that concerns the pumpers. But those looking to the longer term should look at underpriced IPOs with a grain of salt. By setting themselves up for huge first-day returns, they may be paving the way for long-term failure.