Investors, beware the ‘rude shock’ from pledged promoter shares

The Indian equity market has declined steeply since February 20, as the Covid-19 virus began spreading rapidly across the globe. While the Nifty 50 has declined 27.6 per cent, the Sensex is down 27.3 per cent in this period. There could be more pain ahead for a different reason: Pledged shares.

The selling has been broad-based but companies with high levels of shares pledged by promoters become especially vulnerable when share prices plunge. It is common for promoters to raise a loan against the shares owned by them for personal needs or to infuse funds into the business. During steep market declines, as the value of the pledged shares drops, the lenders may be forced to sell these shares to maintain the loan to value (LTV). This drags these stocks still lower, with knock-on effects on the market.

According to exchange filing data compiled by capitaline, out of 4,092 companies, promoters of 705 pledged their shares to raise loans towards the end of 2019. Of these, promoters of about 286 listed companies have pledged more than 50 per cent of their shares. Of these, 44 companies have already seen more than 50 per cent erosion in value since January 1, 2020.

Promoters, including of Future Retail, Future Supply, Dish TV and JP Power Ventures, have pledged 25-50 per cent of their company’s total equity capital.

Worst is not over yet

“Most investors try to avoid stocks where the company’s promoters have pledged shares significantly. This is because investors mostly view high proportion of pledged promoter shares as indicative of the company’s debt position, even though the shares may have been pledged for variuos other reasons, including for personal loans of promoters,” says Chandan Taparia, Technical and Derivatives Analyst, Motilal Oswal Financial Services. Similarly, when markets crash, these shares bear the brunt of selling and, hence, suffer deeper losses.

As prices fall, the steep erosion in value of the collateral results in the NBFC, with which the promoter has pledged his shares, asking for additional margin funds. In the event of non-payment of additional margin within a stipulated time, the NBFC may be forced to sell the securities to recover the margins.

Deepak Jasani, Head of Retail Research at HDFC Securities, says, “despite volume of shares, NBFCs don’t refrain from selling them, given that the legal recourse in case of non-payment/short recovery is quite cumbersome. Also, if the stock has hit the circuit levels multiple times in a single trading session or over consecutive trading sessions, NBFCs don’t offer much of a time buffer but go ahead with a sale, fearing further losses”.

The effect of these margin sell-offs will have minimal impact, if the pledgeshare numbers are low. “If the shares sold due to margin selling is greater than 50 per cent of the daily volume, this could dent the prices further,” says Jasani. Of the 286 companies above, promoters of 146 hold a significant portion of equity over 50 per cent of the total holding. The promoters of Jindal Steel, Emami and DCM Shriram, for instance, have pledged 40-50 per cent of the total market capitalisation of these companies.

Of these 146 companies, 10 have lost more than 70 per cent of investor wealth since February 25, 2020.

Word of caution

Jasani believes that recovery in share prices for such stocks would be slow, unless the percentage of shares pledged is drastically lowered by the promoter.

Stressing the importance of the due diligence to be done by investors, he adds, “factors such as the increasing trend in shares pledged by the promoter and significant value of shares being pledged should not be ignored. Else, investors will have to face rude shocks, during such sell-offs”.

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