Preferential Allotments

Written by Rahul Jain | Updated: Nov 25 2007, 06:39am hrs
With the stock market expected to remain choppy as we approach the year-end, it would be a good time to re-visit valuation strategies and prepare for the New Year well in advance. Now, the conundrum here is to know at what price to get into any particular stock, especially when the market is in the over-valued zone.

One unique way of beating this confusion is to use the preferential allotment route. Confused! Dont be. Preferential allotment is a way of infusing fresh equity in the business by issuing shares or warrants to the specified entities at specific prices to a promoter or promoter group or a person acting in concert (PAC) or institutional players. And this could be a strong tool that investors can use to identify investing opportunities.

The basic reasoning is that if the promoter is pumping in money into the business, they must be confident of its prospects. And when other institutions pick up preferential shares, this also adds to the confidence factor. Moreover, often enough, promoters and institutions have access to more information than available to the lay investor and hence their decisions are well thought of. This can be piggybacked to make gains (see table for evidence).

Changing guidelines

It is the change in guidelines that has made this opportunity to be a viable tool. Earlier, guidelines were seen to be restrictive in nature and did not encourage companies to opt for the preferential allotment route.

In the early 90s, the regulations on preferential allotment were very stringent. As per the first Sebi takeover code in 1994, after the preferential allotment, the allottee had to go through a mandatory open offer to the public. This rule made the preferential route a bit averse for them. Due to this, preferential route was out of favour.

Later, Sebi set up a committee under the chairmanship of Justice Bhagwati, which recommended exempting the need to make an open offer. The rationale was that infusion of capital into the company was in general interest of all shareholders. And then in 1997 the takeover code came into being and allotment via the preferential route was exempted from making open public offers. Shareholders could also send in their approvals through a postal ballot.

When these restrictions were cleared, promoters seemed to make hay. They then used the preferential allotment route to make a quick buck at the expense of the shareholders. And this was due to the fact that there was no basis for pricing a preferential allotment.

Due to this, various promoters, especially of foreign companies listed on Indian bourses, were seen allotting equity shares to themselves at comparatively lower prices than the prevailing market price. And subsequently, selling the shares in the secondary market to make a quick killing at the expense of the existing shareholder.

During the height of the IT boom, many new software companies made preferential allotment to mutual funds at a price higher than that prevailing in the market. But then, such cases are few and far.

But things have changed and this is good news for shareholders and investors. The current guidelines state that the price of the issue must be the average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange during the six months or last two weeks preceding the relevant date, whichever is higher.

The company is also required to disclose the details of the number of shares allotted, and details about the allottee. It also has to disclose the rationale of raising the funds.

Insider knowledge

Promoters know their company better than any outside entity. They are the first one to sense if there is any growth prospect in the business. If the promoter is allotting the shares, it signals that the promoter wants the company to grow. And there is a higher probability that the company will grow at a faster rate in the next couple of years. And this gives good upside in the price of the stock. And the promoter gains from this upside.

From the investors view it can be seen that the share allotted are held for a lock-in period of three years. And this is quite a long period for the investor to earn from this opportunity. Also, the investor knows the price at which the company allots the shares. The issue price can be considered as the benchmark price for the investment.

You can also look at some large-cap stocks where shares or warrants are issued on preferential basis. These are very strong companies and had showed strong growth in the past. Due to its strong identity in the market and high liquidity in the counters, the stocks will be quite expensive to buy.

These counters will deliver growth gradually. On the other hand, there are mid-cap stocks available at low P/E and low prices. But they are risky and liquidity is very low in such counters due to lower equity base. It is difficult to exit when the counter is dry. And in case of downside it will be very difficult to exit at your desired level.

You should also remember that fresh infusion of capital means diluting the equity capital. This will ultimately decrease the earning per share and return on networth. After the allotment of shares or warrants you may see a decline in the share price due to higher valuations.

Sebi guidelines state that if a company allots equity shares, the allottee is required to pay full amount upfront. The funds raised can be deployed instantly in the business. The case is slightly different in warrants. The warrants have a time element as they are converted into equity after a lag. In such cases the allottee is required to pay an upfront of 10% on the total amount.

Warrants are converted into shares at a future date ideally before 18 months from the date of allotment. And the remaining amount is paid after the warrants are converted into equity shares. Warrants are issued because the capital is required in the future date. Both the instruments are issued at specified prices as per the Sebi guidelines. And if warrants are issued, there is no immediate equity dilution.

The flip side

A word of caution here! While, overall, a preferential allotment is a sign of promoter optimism, there are chances of exaggerated optimism as well. And this happens when promoters go in for expansion, just for the sake of it.

You will see plethora of companies that have announced a change or addition to their businesses. Its common place to hear just about anybody getting into real estate and other allied activities, and real estate players wanting to diversify into telecom. In many cases, the existing business itself is running into losses, they have a low return on equity or negative growth. You will find the companies with market price quoting below face value. It seems very lucrative for any investor to enter in these stocks and earn faster returns in less time. These are the companies to stay away from.

Clearly, you are recommended not to plunge instantly when there is preferential allotment without sufficient homework on the company. You should look at the last five years sales, operating profit and net profit and the growth achieved. If the company is in losses then there is no harm in waiting till the new business profits are reflected in the financial results. Do not forget that the preferential route can also be used as a way to offload the existing holding by the promoter at higher price on speculation. At this point you should not go by the herd mentality. One market guru rightly says, It is better to buy the stock at a higher price after the due diligence rather than buying at low when there is no strong fundamental. On the other hand, there is no harm if the company is well known in the market and the fundamentals are strong.

Investors must take note that they are required to be patient after getting exposure in the stocks. You will find majority of the stocks from mid- and small-cap category. These stocks are highly volatile. For them the rule is high risk and high return and vice-versa.

However, Sebi guidelines for preferential issue are quite stringent enough that the promoters cannot hurt the minority shareholders, as the shares are held for three years lock-in period. In case of warrants, the three-year lock-in period starts when they are converted into shares.

Besides promoters, various private equity, financial institutions and FIIs sensed the opportunity to get the exposure in these companies. Ideally, the price at which the shares/warrants are issued is higher than the market price. This is also a good way to know the exact price irrespective of the higher price-earning (P/E) ratio. This will dilute the equity, and simultaneously lower earning per share. The shares allotted to these players have a lock-in period of one year.

Turnaround and revival

There are some companies that have suffered losses or have filed for corporate debt restructuring. These companies have higher finance cost and other issues which turns them into losses. They need immediate infusion of equity to reduce the cost of borrowing. Private equity players show interest in these companies. They buy significant stake through preferential route or buy from the secondary market in the company. The funds are deployed to pay off the debt and remaining funds are infused for expansion or acquisition purpose.

Gradually the company shows a turnaround and generates profits. This may take two or three years. Investors have to wait patiently, however, if you think your target is achieved then offloading of the shares is a better option rather than holding it until the company turnaround.

All the turnaround stories may not go through. For this you must track the stock after regular intervals. Otherwise the best way is to place a target for that stock. If the stock goes above your target price then offload your holding and move out of the stock. If you are bullish on the turnaround story then offload at least your cost and stay invested.

It is very easy for you to invest in a well-known company and be a bit reluctant to invest in lesser known or one with poor track record. Proper research about the companys future plans and updating yourself about the companys new initiatives will remove your resistance.

There are many success stories in the stock market. And the stocks have also delivered outstanding returns in less time. But the returns on your investment will be based upon your risk appetite and your holding capacity.