There are different methods of auctions for buying and selling goods, including financial securities. Not all of them help in transparent price discovery. But many praise the efficiency of the Dutch auction method. Want to know about this Dutch auction strategy?
Also known as descending price auction, the Dutch auction is a type of auction whereby the auctioneer starts with a very high price and incrementally lowers the price until there is a bid for the item. It dates back to the 17th-century Dutch flower market and has been used for stock IPOs in recent times.
In this post, we take a look at the Dutch auction strategy. At the end of the post, you’ll find a backtest of the strategy.
However, if you want hundreds of ideas for a valid short-term trading strategy, please check out other articles.
What does the Dutch auction strategy mean?
Also known as descending or uniform price auction, the Dutch auction is a type of auction whereby the auctioneer starts with a very high price and incrementally lowers the price until there is a bid for the item.
If this first bid is above the reserve price, it wins the auction. This type of auction avoids bidding wars, which is common with typical auction markets, where the price starts low and then rises as multiple bidders compete to buy.
This auction method dates back to the 17th century when Dutch auctions were used to sell fresh flowers in Amsterdam.
It is used to sell different things, including securities. It starts from a maximum price and is then gradually lowered until the securities have been bid on. Thus, the lowest price necessary to sell the entire offering becomes the price at which all securities offered are sold. A descending-price model is used to keep the auction fast-paced, as well as fetch a high price.
This method of auctioning has been used in Treasury bills auctions. The price of an item (government T-bill) is gradually lowered until it meets a responsive bid or offer that can take out the entire offering, and is then sold. The auction system is often used in risk arbitrage, initial public offering (IPOs), and corporate repurchases (when companies buy back shares – buybacks are good when done at cheap prices).
In a corporate repurchase, the company sets a price range and invites shareholders to tender their shares within that range. If more shares are tendered than may be lawfully purchased under the specified terms, proration may be used (often an additional amount equal to 20% of outstanding shares can be purchased), and the tender offer is open for a specific amount of time (for example, 20 days). The amount claimed to be purchased can be sold at the paid price.
What is a Dutch auction in stocks?
In stocks, a Dutch auction occurs when investors submit bids for a security offering (IPO), indicating the amount and price of the securities they are willing to purchase. After considering all offers, the price is set at the greatest price at which the entire offering may be sold. One of the most common uses of a Dutch auction in stocks is during initial public offerings (IPOs).
In a traditional IPO, the investment banks underwriting the IPO do what is called a roadshow where they schedule meetings with brokers, institutional investors, financial analysts, and more. And during this roadshow, they advertise the stock that will be offered for sale and gather data that would help determine the proper price. Individual investors are not invited. On the other hand, with a Dutch auction IPO, the process is democratized so that individual investors can participate.
When using a Dutch auction for an IPO, the auction process, rather than a roadshow by an investment bank, determines the IPO price. Here is how it happens: potential investors submit their bids for the number of shares they want to purchase as well as the price they are willing to pay.
Following the submission of all bids, the placement is assigned to the bidders, from the highest bid to the lowest bid, continuing until all shares are assigned. The lowest price at which all the shares have been taken becomes the price of the IPO, such that even those that bided higher prices would have to buy at that price.
Dutch auction example
For example, let’s say a company wants to use the Dutch auction for an IPO and plans to issue 100,000 shares for the highest price possible per share.
It sets the initial price at $200 per share. An investor may bid 20,000 shares at $190, while another offers $180 for 50,000 shares. A third investor may offer $170 for $40,000 shares. At this point, all the 100,000 shares would have been taken out by the submitted bids. So, they stop the bidding and set the IPO price at $170 per share, and this would be the price every bidder would buy the stock at. Even the investor that priced it at $190 would still buy at $170.
What is the advantage of a Dutch auction? Dutch auction vs IPOs
There are many benefits of the Dutch auction in an IPO process. These are some of them:
- Reduced transaction costs: Investment banks are more involved in a traditional IPO since they do the roadshow and set the IPO price. A Dutch auction IPO can lower the underwriters’ involvement, which, in turn, lowers transaction costs.
- Democratization of public offerings: In a traditional IPO, shares are generally sold to institutional investors. The process of arranging a standard IPO is mostly controlled by investment banks. They serve as the offering’s underwriters and guide it through roadshows so that institutional investors can buy the issuing company’s stocks at a discount. They are in charge of choosing the IPO’s pricing as well. But in the case of a Dutch auction, small investors are allowed to participate in the sale, and the shares go to the highest bidder whether it’s a large mutual fund or an individual investor.
- Increased transparency: In a traditional IPO, the price is usually set based on the underwriters’ agreement with institutional investors, which is often at a discount to what the stock is worth. Institutional investors profit from this discrepancy by purchasing shares at a discount and selling them as soon as the stock is listed. On the other hand, a Dutch auction is based on the public’s bids, so there is more transparency in the process. The Dutch auction pricing ensures a fairer and more open process in which a variety of bids from various investors are welcomed. This procedure aims to reduce the initial spike that comes with listing a hot company and guarantee that the market determines a fair estimate of the firm’s value.
The Dutch auction method is good in so many ways and can favor both parties, but it seems to favor the sellers slightly more.
For instance, the Dutch auction format is faster than a traditional auction because it avoids the potential for a bidding war, and even the possibility of multiple bids is reduced. Thus, it is ideal for items with short shelf lives, like flowers, tobacco, and fresh food items.
Another point is that the Dutch auction can fetch better prices for sellers. Since the bidders do not know what prices the other bidders are willing to pay, they try to submit higher bids than they would have wanted to give themselves the highest chance of winning the bid.
As a result of the uncertainty about knowing the competitor’s bids, the Dutch auction method can help determine the best asking price, as all bidders try to submit their best opinion of the value of the item. Thus, the Dutch auction can be a useful tool in price discovery since sellers can determine the highest price that bidders are willing to pay, independent of bidding wars and other pressure. This is why some companies have used Dutch auctions to determine their initial public offerings.
On the side of the buyers, the Dutch auction method allows everyone to get into the bidding process. In the case of an IPO, small investors can get more access to IPOs unlike what happens with the traditional offering process where investment banks funnel IPO shares to their best clients.
However, some may argue that buyers pay more for stock sold in Dutch auctions because under the traditional method, investment banks typically underprice offerings to make sure all the shares sell.
In addition, some argue that shareholders benefit when shares are sold using traditional methods, as the initial pop often associated with traditional IPOs creates an image of success that drives the stock even higher in the days and weeks that follow. This may be one of the reasons shares sold in a Dutch auction don’t usually have the same run-up in price immediately after they begin trading.
Does everyone get the same price in a Dutch auction?
Yes, everyone gets the same price in a Dutch auction because the price at which all the offered security is assigned is taken as the issuing price of the security. Thus, anyone offering that price or higher would be assigned the security and pay that amount, regardless of their initial bid prices.
Is Dutch auction efficient?
Dutch auctions have been praised as more efficient and fairer as they prevent underwriters from allocating stocks to known or favored clients. The Dutch auction method allows everyone to participate in the bidding process. So, with the Dutch auction, the price discovery is transparent and democratic.
Dutch auction trading example
Let’s say that Company XYZ is using a Dutch auction to price its shares for an IPO. The company is looking to sell a total of 1000 shares in this IPO but doesn’t know the best price, so it decides to use a Dutch auction and invite investors to send their bids.
Investor A places a bid for 400 shares at $250
Investor B places a bid for 50 shares at $300
Investor C places a bid for 100 shares at $200
Investor D places a bid for 80 shares at $350
Investor E places a bid for 370 shares at $180
Investor F places a bid for 500 shares at $150
Investor D: 80 shares at $350 (1,000 – 80 = 920 shares remaining)
Investor B: 50 shares at $300 (920 – 50 = 870 shares remaining)
Investor A: 400 shares at $250 (870 – 400 = 470 shares remaining)
Investor C: 100 shares at $200 (470 – 100 = 370 shares remaining)
Investor E: 370 shares at $180 (370 – 370 = 0 shares remaining)
Investor F: 500 shares at $150 (zero shares assigned)
From the above, the IPO would be priced at $180 per share because the last bid of 370 shares at $180 completed the total number of shares that Company XYZ is issuing.
All investors that price at $180 or above would buy the shares at $180, regardless of their initial bid prices. Thus, investors D, B, A, C, and E would be able to purchase shares for $180 instead of their initial bids of $350, $300, $250, $200, and $180, respectively. Investor F would not get any shares because all the 1000 shares have been assigned before their bid price is reached.
Dutch auction strategy backtest
The best-known example of an IPO that used a Dutch auction was Google’s IPO in 2004. Google (Alphabet) used a Dutch auction to reduce the underpricing when it went public.
Can we backtest and compare the performance of a Dutch auction process?
We at Quantified Strategies certainly can’t, but we can look at previous research to gather evidence:
First, IPOs, in general, are poor investments. As a group, IPOs underperform the market. Jay Ritter at the University of Florida, who has specialized in collecting performance data of IPOs in the US for decades, concludes that most IPOs experience early gains for later falling and underperforming.
However, in the long run, IPOs underperform massively.
That IPOs underperform is perhaps to be expected. Most IPOs are small companies with no moats and unproven business models. Please also read our article called IPO trading strategy.
This is what Jay Ritter writes:
I find that in the 3 years after going public these firms significantly underperformed a set of comparable firms matched by size and industry.
Based on this, a relevant question to ask might be:
Do IPOs based on Dutch auctions perform better than traditional IPOs?
Surprisingly little research has been done. We have turned every stone and found just one research report called Dutch-auction IPOs: institutional development and underpricing performance by Mary Ann Robinson and Richard Robinson.
One of the reasons for the sparse research is that most IPOs are not using a Dutch auction bidding process. Nevertheless, the Robinsons concluded the following:
The evidence indicates smaller magnitudes of underpricing of Dutch-auctioned IPOs relative to traditional IPOs. A multi-variate analysis indicates, however, that this smaller degree of underpricing is due to factors other than the Dutch-auction process. The evidence strongly reinforces the institutional rationing hypothesis for underpricing. It also contributes to the international evidence of the failure of auctioned IPOs to avoid underpricing.
Let this be the conclusion of the article!