Speculative returns in the Neuer Market.

Macy, Anne ; Terry, Neil

ABSTRACT

This paper examines the speculator's return on equities listed in the German Neuer Market during the twenty-month window surrounding the initiation of the euro currency. Empirical evidence indicates that the general performance of the market, timing of the initial public offering in relation to the initiation of the euro currency, percentage of the stock that is free floating, and industry classification influence speculative returns. A Kruskal-Wallis test is employed to compare the price appreciation of initial public offerings in ten different industries. The industry with the largest one-day return is financial services, while the medical technology industry is found to be the worst performer.

INTRODUCTION

Young firms need capital to fund their expansions and growth. Investors recognize the potential of new, young firms for quick stock price appreciation. The German Stock Market established the Neuer Market in 1997 for the purpose of matching young firms with investors seeking price growth appreciation and willing to assume the risk associated with small-capitalization stocks. The Neuer Market is modeled as a German equivalent of the NASDAQ in the United States. Since its inception, the Neuer Market has grown to over 300 firms and represents the majority of the turnover of all the German stock exchanges.

The purpose of this study is to examine the determinants of speculative returns in the Neuer Market. Specific areas of interest include the impact of market conditions, liquidity and industry classifications on speculative returns. This paper is organized as follows. First, background information on the Neuer Market including admission criteria is provided. The next section offers a brief discussion of the characteristics of initial public offerings within the Neuer Market. The third section presents an empirical evaluation of the determinants of speculative returns. This is followed by a comparative industry analysis. The final section offers conclusions and suggestions for future research.

BACKGROUND

Three segments compose the German Stock Market. Official trading is the home of established, large-capitalization stocks, much like the New York Stock Exchange. The approval criteria and continuing obligations of firms listed for official trading is the most stringent of the three segments. A step below the Official Market is the Regulated Market. The volume issued and percent floated requirements are lower for firms in this market. The third segment, the Unofficial Regulated Market, is the largest market with few approval prerequisites and no continuing obligations. Warrants and foreign shares dominate it. Recognizing a need to promote growth stocks, the Frankfurt Stock Exchange established the Neuer Market within the Unofficial Regulated Market. The Neuer Market fulfills a hole in German capital markets. Young companies need capital to grow. The traditional bank loan is not befitting innovative firms starved for cash. The small firms are not established enough to receive lower interest rates and the liquidity demand of interest payments is draining on the firms and not guaranteed to the banks. The Neuer Market allows these growth-oriented firms to solicit funds from investors looking for potentially high returns and willing to undertake the corresponding risk. In addition, the venture capital that helped initiate the firms can be recaptured at the initial public offering. By offering a potentially high return exit strategy to venture capital, the Neuer Market encourages further venture capital investment.

While officially in the Unofficial Regulated Market, Neuer Market firms follow more stringent criteria for listing. The additional requirements provide greater transparency and liquidity to investors. Firms listed on the Neuer Market must publish reports quarterly and annually. In contrast, firms listed on the Official Market are only required to publish a report every six months. Neuer Market firms must also have at least one meeting for analysts each year. No such requirement exists for the other markets. Firms in the Official Market must publish their reports in German and foreign firms must publish in German and English. All firms in the Neuer Market must publish in both German and English. In addition, all firms must publish in accordance to either International Accounting Standards or U.S. Generally Accepted Accounting Principles. This makes the firms internationally comparable (De Grauwe, 2000). The increased reporting of the financials should help analysts and investors evaluate the firms more fully. Because the firms are more easily comparable, both with other domestic firms and international firms, competition for investment flows is encouraged. The transparency lowers the risk associated with the investment.

Firms must satisfy three criteria for admission to the Neuer Market. All firms must have at least two designated sponsors. The designated sponsors act like specialists in providing liquidity through binding purchases and sales of the stock. The company owners agree to a lock-up period of at least six months before they are eligible to sell their shares. This increases confidence in the company and ensures that the management will remain as the firm goes public. Finally, each firm agrees to consider all takeover bids with a goal of increasing shareholder value. Upon fulfilling the requirements for listing, each firm must float at least 20% of the total shareholder equity with a minimum value of Euro 5 million. These liquidity standards ensure marketability.

INITIAL PUBLIC OFFERINGS

Because it is a new market segment and the firms are young, the Neuer Market is the site of initial public offerings (IPOs). During 1997, thirteen firms held IPOs for a total market capitalization of Euro 4,138 million. It represented just 0.57% of the total capitalization of the Frankfurt Stock Exchange. In 1998, forty-five firms issued IPOs bringing the total capitalization to just over Euro 26 million. At the end of 1999, 198 firms were listed on the Neuer Market with a market capitalization of Euro 111,276 million, representing 8.01% of the total German stock market. In 2000, another 133 firms held IPOs, making the Neuer Market the home of 26.56% of all domestic shares. Fifty-six foreign companies are listed. While the total Euro value of the shares traded is a modest percent of the total value of the German stock market, the turnover on the Neuer Market has been over 60% of the turnover on the entire market since inception. The equities on the Neuer Market returned 173.9% in 1998, 66.2% in 1999 and -39% in 2000.

The backbone of the Neuer Market is technology. The firms can be divided into ten industries. In terms of capitalization, the largest industries are technology and Internet, each making up one-fifth of the total value. Financial services at 18.38% and biotechnology at 13.76% are third and fourth largest. Media and entertainment, industrial services, and telecommunications each make up a little over 5% of the total value. Software, information technology services and medical technology are the smallest sectors.

The initial price and the opening price of IPOs are rarely the same, leading many investors to speculate on new issues. Underwriters, unable to accurately price an issue and wanting the issue to be a success, have a bias to underprice new issues (Reilly & Hatfield, 1969). This discrepancy leads to a positive speculative return for the initial owners. Empirical evidence from the United States has shown that the average underprice is 15% but varies over time (Ibbotson, 1975; Reilly, 1977; Neuberger & Lachapelle, 1983; Ritter, 1991). Further studies have examined the speed of price adjustment and found it usually occurs within one day (Hanley, 1993; Ibbotson, Sindelar & Ritter, 1994). The speculative return is present only initially and usually to institutional investors who are better able to gain access to the issue (Hanley & Wilhelm, 1995).

Within the Neuer Market over ninety percent of the IPOs had positive speculative returns between 1997 and 2001. In both 1997 and 1998, only one firm each year earned a negative return. SER Systeme returned a negative 48.86% in 1997 while Lobster Network Storage earned a negative 14.29% in 1998. The high return was 323.08% in 1997 and 308.16% in 1998. The average speculative return was 57.35% in 1997 and 75.27% in 1998. In 1999, the returns ranged from -20.83% to 360.87% and only twelve of the 132 firms listing earned negative returns. Sixteen firms earned negative speculative returns in 2000, with the majority coming in the last six months. The range of speculative returns was -25% to 433.33% for 2000. The average speculative return was lower in 1999 and 2000 than in the prior years but still high at 44.89% and 45.94%, respectively.

DETERMINANTS OF SPECULATIVE RETURNS

The German Neuer Market offers opportunities for new firms to obtain capital for growth. The twenty-month window surrounding the January 1999 initiation of the euro currency was a very active time period for the Neuer Market. In this section standard regression analysis is employed to investigate the determinants of speculative returns. The sample is drawn from 290 firms listed as initial public offering in the German Neuer Market during the twenty-month euro initiation period. The data source is the Neuer Market company listing on the Internet at www.neuermarkt.com.

The empirical model in this study is defined as RETURNS = f (EURO, INDEX, VOLUME, FLOAT, INDUSTRY), where:

RETURNS = first quote minus subscription price divided by subscription price;

EURO = the number of months before or after the January 1999 initiation of the euro;

INDEX = the value of the Neuer Market index during the subscription period;

VOLUME = placement volume of the stock in millions of shares;

FLOAT = percent of the stock that is free floated at the time of the IPO;

INDUSTRY = 1 if the firm is classified as a high-tech firm; 0 otherwise.

The estimated empirical relationship between the explanatory variables and speculative returns is presented in Table 1. The model explains thirty-one percent of the variance in speculative returns. None of the independent variables have a correlation higher than 0.35, suggesting that excessive multicollinearity is not a problem. Four of the five variables in the model are statistically significant at the five-percent level.

The positive and significant coefficient on the EURO variable is an interesting result. There appears to have been an excitement in the European financial markets in the days leading to the formal establishment of the new euro currency. This excitement entered the IPO market resulting in positive speculative returns for companies listing in the formative time period. The depreciation of the euro relative to the dollar ex post the January 1999 initiation period seems to have hampered speculative returns. The general health of the Neuer Market also has a positive and significant impact on speculative returns. One value that all investors can readily witness is the value of the index during the subscription period. Because of the tendency to underprice IPOs, many investors speculate on new shares. As investors garner speculative returns pushing the index up, others are enticed into the market seeking the return. The investors act in a way that brings about speculative returns, confirming their positive intuition. Similarly, in a declining market investors turn away because of the negative psychology in the market. The size of the IPO issue did not have an impact on speculative returns. The VOLUME variable is negative but not statistically significant. This result is not surprising given that 195 of the firms executed their greenshoe option at the time of placement. This implies that the marketability goal of the Neuer Market has been satisfied.

The independent variables FLOAT and INDUSTRY both have a negative and significant impact on speculative returns. The negative sign on the free float variable indicates that the Neuer Market is rational and liquid. As the percent of the stock that is floated increases, the supply offered to the public increases. This increase in supply reduces the potential shortage of the issue and limits the opportunity for a speculative return. The more stringent filling and transparency requirements that the Neuer Market established have encouraged a more efficient market. The empirical results also indicate that industries outside of the high-tech sectors earned a speculative return greater than high-tech companies. Industries classified as part of the high-tech sector include biotechnology, Internet, information technology services, technology services, medical technology, and software, while financial services, industrial services, media & entertainment, and telecommunications are not classified as high-tech sectors. One explanation for the negative return associated with the high-tech industries is the saturation of initial public offerings. Over seventy-five percent of the IPOs included in this study come from one of the high-tech industries. In fact, the Internet and technology services industries have fifty-eight issues each compared to a mere six in the financial services industry. Negative publicity about possible overvaluation of the high-tech sector in U.S. financial markets may have also contributed to the lack of speculative returns for high-tech in the Neuer Market. The absence of proven profit potential may have also limited the amount of speculation put forth on the copious high-tech offerings.

INDUSTRY COMPARISON

Is there a difference in the speculative returns by industry? Empirical evidence from the previous section implies that a difference exists. In this section we compare speculative returns in ten different sectors during a twenty-month window around the initiation of the euro. Once again, the sample is drawn from 290 firms listed as initial public offerings in the German Neuer Market. The ten industry classification are biotechnology, financial services, industrial services, Internet, information technology services, media & entertainment, medical technology, software, technology, and telecommunications. The statistical methodology incorporates a nonparametric approach to comparing initial price appreciation and industry. The Kruskal-Wallis test is employed because it offers the most powerful test statistic in a completely randomized design without assuming a normal distribution. The Kruskal-Wallis test is designed to be sensitive against differences among means in the k populations and is extremely useful when the alternative hypothesis is that the k populations do not have identical means. The Kruskal-Wallis test is used in this study to test the null hypothesis that the k speculative returns come from an identical distribution function, regardless of industry. For a complete description of the Kruskal-Wallis test see Conover (1980). The specific equations used in the calculations are as follows:

(1) N = [k.summation over (i=1)] [n.sub.i]

(2) [R.sub.i] = [n.summation over (j=1)] R[X.sub.[??]]

(3) [R.sub.j] = [c.summation over (i=1)] [O.sub.[??]][R.sub.i]

(4) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]

(5) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]

(6) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]

where R is defined as the variable rank and N is the total number of observations. The first three equations are used to find average ranks. Equation (4) is used to calculate the sample variance, while equation (5) represents the test statistic. If, and only if, the null hypothesis is rejected, equation (6) is employed to determine multiple comparisons of speculative returns across the various industries.

The empirical approach yields a T-value of 16.87 (p-value = .0001), indicating a significant difference in speculative returns across the ten industries. Table 2 presents a summary of the average rank return for each industry. Assuming an alpha level of .05, the empirical results indicate that the financial services sector offered a speculative return that was significantly greater than the other nine sectors. One possible explanation for the success of financial services industry is the observation that only six firms listed during the research window, providing less market saturation than other sectors. A second possible explanation is that the financial services industry is more established and better understood than the high-tech alternatives represented in many of the other industries. One strength of the financial services industry is the ability to blend traditional investing opportunities with opportunities put forth by information technology in the new economy. Traditional broker services can be enhanced with online access and information. The industry with the second largest speculative return is the telecommunications industry. Although the telecommunications industry earns a speculative return that is statistically greater than industries ranked three through ten, recent activities in global markets indicate that the telecommunications industry was in the midst of a speculative bubble during the research window. It is doubtful that the telecommunications industry would still be able to separate itself from the other industries if new telecommunications IPOs are put forth in the present environment.

Industries ranked three through nine do not have a speculative return rank that is statistically different. The industries include biotechnology, industrial services, Internet, information technology services, media & entertainment, software, and technology. The fact that most industries do not stand out as above (or below) average performers indicates that the German Neuer Market is a rational and liquid equities market. There is little evidence of euro euphoria overvaluing certain industries and undervaluing others. The smallest speculative return is in the medical technology industry. The average speculative return rank of 178 in the medical technology is significantly lower (alpha-level of .05) than the nine other industries. One possible reason for the poor performance of the medical technology industry is that the industry was hurt by price transparency offered by the establishment of the euro currency. A second possible explanation is the anticipated difficulty of gaining approval for medical technology improvements across the various European nations. Finally, the medical technology sector is extremely speculative because companies listing in the industry do not have existing products with a promising cash flow opportunity. Most of the medical technology companies are in the process of conducting product research and development but are several years away from returning a profit.

CONCLUSIONS

The Neuer Market encourages the expansion of the stock market in a society with an underdeveloped equity market. The Neuer Market estimates that while over a half of a million corporations exist in Germany, less than 5,000 are stock corporations and under 1,000 have an official listing. It believes another 2,000 corporations are eligible for listing. In contrast, over 3,000 are listed on the New York Stock Exchange and over 5,000 firms are listed on the NASDAQ. Thus, the Neuer Market provides an outlet for German firms seeking to go public. IPOs are unique in that the issues tend to be underpriced in order to ensure success. Because of this inefficiency, investors speculate on new issues to earn the potentially large and positive initial return.

The empirical results of this study indicate that the conditions of the overall market at the time of issue have a significant impact on the speculative return in the Neuer Market. Initial public issues offered greater speculative returns to investors ex ante the formal introduction of the euro currency. The potential efficiency gains of increased transparency, decreased transportation costs, and decreased exchange costs among other benefits contributed to the pre-euro positive speculative return. Higher returns were also realized to those issues occurring in the time period following a rising market. Investors witnessing other investors earning speculative returns are enticed into the market causing further speculative returns. The results corresponding to supply conditions are consistent with a liquid market. The issue volume and free float percentage have a negative impact on speculative return. This is mostly likely due to the large number of greenshoe options exercised and the scarcity of the issues. This study also provides evidence that speculative returns are different across industries. The industry with the largest speculative return during the research time period is financial services. The industry with the poorest performance is medical technology.

The goal of the Neuer Market is to increase the number of firms listed in Germany. By providing a vehicle to raise capital, the Neuer Market encourages young firms to go public. The stringent rules and increased transparency of financial data provide potential investors with greater certainty in their investments. This encourages a wider investment pool and reduces the risk premium firms must pay for capital as the market deepens. The establishment of a new financial market in an advanced, industrial nation provides an opportunity for several potential research endeavors in addition to this analysis on speculative returns. One potential avenue is a comparison of speculative returns and index performance between the Neuer Market and its U.S. equivalent, the NASDAQ. Future research could also investigate developing equity markets in other European countries including Italy and Switzerland. A potential direct extension of this research is an examination of the long-run performance of these initial public offerings. In the end, the results of this study are of a preliminary nature and more research is needed before any definitive conclusions about the Neuer Market can be made.

REFERENCES

Conover, W. (1980). Practical Nonparametric Statistics. New York: John Wiley & Sons Publishing.

De Grauwe, P. (2000). Economics of Monetary Union. New York: Oxford University Press.

Ibbotson, R.G. (1975). Price Performance of Common Stock New Issues. Journal of Financial Economics, 2(3), 235-272.

Hanley, K.W. (1993). Underpricing of Initial Public Offerings and the Partial Adjustment Phenomenon. Journal of Financial Economics, 34(2), 231-250.

Hanley, K.W. & W.J. Wilhelm Jr. (1995). Evidence on the Allocation of Initial Public Offerings. Journal of Financial Economics, 37(2), 239-257.

Ibbotson, R.G., J.L. Sindelar & J.R. Ritter (1994). The Market Problems with the Pricing of Initial Public Offerings. Journal of Applied Corporate Finance, 7(1), 66-74.

Neuberger, B.M. & C.A. Lachapelle (1983). Unseasoned New Issue Price Performance on Three Tiers: 1975-1980. Financial Management, 12(3), 23-28.

Reilly, F.K. (1977). New Issues Revisited. Financial Management, 6(4), 28-42.

Reilly, F.K. & K. Hatfield (1969). Investor Experience with New Stock Issues. Financial Analysts Journal, 25(5), 73-80.

Ritter, J.R. The Long-Run Performance of Initial Public Offerings. Journal of Finance, 46(1), 3-27.

Anne Macy, West Texas A&M University

Neil Terry, West Texas A&M University

Table 1: Determinants of Speculative Returns

Variables Coefficients t-statistics

Intercept 65.050 5.44 *
EURO 1.242 2.94 *
INDEX 2.184 9.85 *
VOLUME -0.606 -0.53
FLOAT -0.583 -2.23 *
INDUSTRY -4.071 -2.02 *

* Significant at the .05 level;
N = 290; R-square = .3122; F-value = 24.61

Table 2: Mean Rank of Speculative Returns by Industry

Industry Number of Firms Mean Rank

Biotechnology 13 153.0
Financial Services 6 85.8
Industrial Services 13 153.6
Internet 58 143.8
Information Technology 32 163.9
Services
Media & Entertainment 36 138.4
Medical Technology 10 178.0
Software 47 142.3
Technology 58 141.6
Telecommunications 17 114.5

* Note: Lower mean rank implies higher speculative returns