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

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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.

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

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