OPINION 

The flotation game

Chris Dillow

Chris Dillow
The flotation game

Investors who have been disappointed by Saga's share price since its flotation can learn something from the great 20th century mathematician John von Neumann.

Saga's post-flotation fall fits a well-established pattern. Newly issued shares tend to do well on the day of their flotation, only to slide back later. This phenomenon of initial public offering underperformance was first noted in the US by Jay Ritter at the University of Florida, but it also exists in the UK. A study of over 2,000 flotations by Alan Gregory at the University of Exeter found that newly issued shares underperform comparable ones by an average of 10.8 per cent in the two years after flotation.

One reason for this underperformance is that the companies' owners know more than outsiders do about their businesses and they exploit this information to sell at the best possible time. (This might not be true if the company is owned by the government - privatisations are a different story.)

But why don't buyers see this? One reason is that they are stuck in the wrong way of thinking about economic problems; we can call this the parametric paradigm. In many economic choices we make, we think of the environment as consisting of given parameters - prices, interest rates and so on. Such thinking is perfectly sensible for countless choices we make about what to buy or how to save.

And this is where von Neumann enters. Back in 1944, along with Oskar Morgenstern, he pointed out that this isn't the only way to think about economic matters. Sometimes, the environment we face isn't fixed but is instead the outcome of the choices made by a few others and those others are anticipating our choices. And we should anticipate theirs and they should anticipate our anticipations and so on. Some economic issues aren't a question of choice subject to given parameters but are instead games of strategy, they said. And so game theory was born.

And here's the problem. Owners who are thinking of floating their businesses use the strategic paradigm and ask: when will others be most willing to buy? But buyers don't think strategically. If they asked 'why is this person who is presumably more knowledgeable than me so keen to sell?' they'd be wary of new issues. But they don't ask this. Instead, they are stuck in the parametric paradigm and fail to see that sellers are trying to strategically maximise the value of their superior knowledge.

In this sense, buyers of Saga (or Pets at Home) have made the mistake we've all made when we've tried to find a short cut and got ourselves stuck in traffic. Sometimes, we fail to see that other people are also making informed choices, and their choices can make us worse off. David Navon at the University of Haifa has called this failure the egocentric framing error. Chess-players of moderate ability will recognise this problem. We often play better when instead of asking 'what's my best move?' we ask 'how can I stop my opponent's best move?'

We should think of share flotations as being like a game. And investors should remember that, on average, they are a losing one.

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