Idea Farm: What Music Hits Tell Us About IPOs

  • Music Chart Success Can Be Random
  • Therefore, beware of post-IPO rallies
  • Lots of idea-generating content

What makes a hit song? In 2006, a Columbia University PhD student named Michael Salganik set out to answer this question. Or to quote directly from the study that followed: “How can success in cultural markets be both remarkably distinct from average performance, and yet so difficult to anticipate for profit-driven experts armed with in-depth market research?

To do this, he and his colleagues devised a clever experiment. They created a website of 48 songs by unknown artists, which users could save and then upload to their own private library. The academics then randomly assigned 14,341 participants to browse and rate songs in the library alone, or in one of eight virtual social worlds where they could view information about how often each song had been downloaded by users. previous participants in their group.

Users, Salganik found, were more likely to download songs that others had already downloaded. But we also didn’t know what made a hit song. Each world ended up picking its own hit, with little correlation to the quality of each song determined by solo browsers.

The creation of a hit hit, the study concludes, was both socially conditioned and random.

In his excellent 2021 book on the history of venture capital, The power law, writer Sebastian Mallaby cites Salganik’s experiment as an example of the role that feedback effects and luck can play in business success. Repeat the story again, and the Harry Potter series or Facebook might never have gone viral.

Likewise, the stock market can be subject to unpredictable bursts of collective enthusiasm. Since 2020, this has been most apparent in the meme stocks phenomenon, in which armies of retail investors have placed leveraged bets on battered companies such as the video game retailer Gamestop (US: GME) and movie channel AMC Entertainment (US: AMC).

But there is also a similar quality to stock market debuts. In the first month after pricing their offering, companies that have raised at least £100m in the premium market in London over the past decade are up 7% on average and less than a third of value has lost. But one THIS analysis of trading data suggests that early performance has almost no correlation with longer-term returns.

In fact, the same group of stocks averaged an average annual negative total return of 12%. Only a fifth can boast a positive average annual return of at least 10%, a level that could be considered attractive from the outset.

We must be careful not to over-extrapolate from this limited data sample or over-emphasize the similarities of network effects in cultural and financial markets. We know, for example, that bankers, sponsors, and business owners often seek to time floats during times when investors are most bullish. In the real world, pop fans also tend to turn to music from artists they already know.

This last point may also be true for investors buying new issues, which may help explain the buzz around certain listings. In these cases, the trend can be amplified by short-term traders.

Either way, investors would do well to remember that early performance has little to do with how good a new issue is. While there is at least one tangible social benefit to buying and listening to chart toppers – in the form of collective enjoyment and recognition of a shared experience – the stock market equivalent has many more pitfalls.

External links:

Experimental study of inequality and unpredictability in an artificial cultural market (Salganik, Dodds & Watts)

The power law (Malby)