Watch out for pledged shares; they're key to a company's health

Sep 02 2013, 08:12 IST
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Cos with high amount of pledged promoter shareholding are susceptible to erosion in stock prices. Cos with high amount of pledged promoter shareholding are susceptible to erosion in stock prices.
SummaryCos with high amount of pledged promoter shareholding are susceptible to erosion in stock prices.

Companies with high amount of pledged promoter shareholding are susceptible to erosion in stock prices. The number of such companies has seen the highest quarterly jump in at least three years

A close look into the finances of companies is a must for stock market investors, especially at a time when there has been a rise in uncertainty, volatility and dynamics around rupee, while interest rates and liquidity are fast altering the financial position of companies. As fund raising for companies is becoming a challenge, pledging of shares by promoters has been on the rise. For the quarter ended June 2013, the percentage of promoter holding pledged witnessed the highest quarterly jump in at least three years — 11.4 per cent in March 2013 to 12.4 per cent in June 2013 — with a large number of companies witnessing a sharp rise in their promoters holding being pledged.

So as the environment opens up new challenges for the economy and the companies operating within the same, investors need to carefully analyse the companies before they enter them in search of high returns and fall into the valuation trap.

A look into the share prices of the companies with market capital of over Rs 1,000 crore and with significant rise in their promoters holding pledged over the previous quarter, shows a significant fall in their prices. While the Sensex fell by 6 per cent between January 1 and August 29, the share price of several of these companies fell by over 40 per cent in the same period.

Rise in share pledging

According to a report prepared by ICICIdirect based on shareholding data made public by 3,935 companies, over the last couple of years the percentage of promoters holding pledged has risen sharply from 9.4 per cent in June 2011 and has now gone up to 12.4 per cent. There has also been a significant rise in the percentage of total equity pledged in the system. While the pledged shares stood at 6 per cent of the total equity in March 2013, it has gone up to 6.6 per cent in just one quarter.

While there are various sources that companies and their promoters adopt to raise funds for their business needs or their personal needs, pledging of shares is one such source that gained prominence. Promoters in this method pledge their shares with lenders in the market to meet their requirement.

“These loans typically have a tenure of one to three years and carry a margin requirement of two or three times,” said the ICICIdirect report. This means that the promoters have to keep shares worth 2-3 times the money borrowed.

Market experts say that in the current environment, banks have grown risk averse and are largely giving loans backed by collaterals which is also leading to a rise in pledging of shares.

“Banks are going for largely collateral backed lending in the current environment and while it is getting tough to raise funds a lot of promoters are resorting to pledging of shares to raise funds,” said Rikesh Parikh,VP, equity strategies, Motilal Oswal Securities.

Rise in pledging is a result of overall stress in the system. While in some cases promoters may have pledged shares to fund their own contribution for any new project, in other cases their pledging would have gone up with fall in their share prices to make up for additional security requirement against the borrowing.

While the overall system is witnessing the pressure, there are some sectors that are positioned much worse than others. The infrastructure and real estate sector are the worst positioned in terms of the promoters holding that is pledged. For Infrastructure sector 31.5 per cent of the promoters holding stands pledged while for real estate sector it stands at 30.3 per cent.

Next in line are textile and the capital goods sector where it stands at 27.7 and 22.2 per cent respectively.

Where does the risk lie?

As the fund raised by way of pledging of shares come at a premium, higher pledging by the promoter reflects a weak financial health of the company and the promoter and his inability to get cheaper source of funding.

The risks lie on several fronts. On the business front, such companies may find it tough to maintain their margins as most of the borrowing through pledging of shares is at a higher cost. In case of pledged shares, the lenders hold the right to sell the shares in case the promoter defaults on his repayment and the lender can sell the shares in the open market which may lead to fall in share prices. In certain cases, the promoters may also end up losing management control of the company.

In a recent case, State Bank of India in April 2013 sold shares of United Spirits and Mangalore Chemicals and Fertilisers that were pledged to them by Vijay Mallya against money lent to Kingfisher Airlines. The bank moved to do so after the airlines failed to repay its loan.

Also in a falling market scenario, like the one we are in now, if the share prices fall below a certain limit then the promoter is required to provide additional securities or make some payment.

“Companies with a high proportion of pledged promoter holding are susceptible to such erosion in stock prices,” said Pankaj Pandey, head of research at ICICI Securities.

Stay away from such companies

Valuation trap is something that investors may easily fall into when it comes to these companies. A number of these companies are trading lower as a result of a decline in their share prices but these companies may not be adding much value to their equity shareholders. While their interest outgo would be in double digit, experts say that their growth may be in single digit and therefore while their share prices may appear to be lower and available at cheaper prices, they may not bring value to the shareholders.

Also, at a time when the Reserve Bank of India has taken measures to tighten the liquidity and the US may begin tapering of its quantitative easing programme in September, liquidity situation may further tighten making things even more worse for some of these companies.

“In a situation like this, investors should avoid such companies,” said Pandey. Parikh advises investors to go with companies that have good cash flow and have low debt-to-equity ratio in these times when liquidity is likely to remain tight and companies that are heavily leveraged may come under pressure.

“Till the current environment prevails, such companies will find it increasingly tough to maintain their margins and therefore investors should stay away from them,” said Parikh.Investors, however, need to check on various details of the pledging before they get into the stocks.

“If the pledging is less, up to one-third of the promoters holding and has been done for purposes linked to core business, then there is not much of an issue. But if it has been done for other purposes and the shares have been pledged with NBFCs who charge a higher rate then investors need to be careful,” said Gaurav Dua, head of research at Sharekhan

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