We all know equity investment comes with risk. The reason being there are so many parameters for investors to check before picking up stocks. We are going to talk about one such parameter in this article – the pledging of shares.
Who all owns the company’s shares?
Before we understand pledging, it is essential to understand the stakeholders of the company. Below are various stakeholders:
- Promoters – are the owners of the business. They are those who have a controlling stake in the company and hold senior executive positions. Promoter may or may not be CEO. In most cases, they are the largest investors in the company.
- FII – Foreign Institutional Investors are those investors who put their money into the Indian equity market and stay outside India.
- DII – Domestic Institutional Investors are high-worth investors (including mutual funds) that invest in different stocks.
What is pledging of shares?
When you need a loan – what do you do? You go to the bank and ask for the loan. When a bank gives you a loan, they look for collateral – a property, some asset, etc.
Let us assume you are the owner of ABC Limited, which has a market cap of Rs 10,000 crore. You own 60% of the shares, and hence you have shares worth Rs 6,000 crore.
A company needs funds for various reasons. It could be for working capital requirements, carrying out new acquisitions, funding other ventures, personal obligations, and more. It can raise funds through investors, issuing bonds, etc. When the company is not in a position to raise funds through traditional means, the last option for promoters is to go to a bank and take a loan. The bank will give a loan against the shares – the promoter pledge shares.
What happens when the shares are pledged?
You have Rs 6,000 crore of shares. You want a loan of Rs 3,000 crore, and hence you have to pledge your 50% shares. In some cases, the bank may not consider the current price of shares the same as collateral value. The difference between the market value of shares and the value accepted as collateral is known as a haircut.
Assuming there was no haircut and you got Rs 3,000 crore by pledging your 50% shares.
- When you pledge your shares, you retain the ownership of all stocks and continue to earn interest and dividends on those shares.
- If the price of your shares falls by 20 percent after a year, your 50% shares are now only worth Rs 2,400 crore. A threshold amount is decided below which the collateral value should not go. Assuming it was Rs 2,700 crore. Now, you will either have to pay the difference of Rs 300 crore or pledge more shares to make the collateral price of Rs 2,700.
- If you cannot make the payment, the bank has the right to sell the pledged shares in the open market.
- Once the pledged shares are sold in the open market, your holding in the company will reduce. For example, if the bank sold shares worth Rs 500 crore, your holding in the company will reduce to 55% from earlier 60%.
Why is pledging dangerous for investors?
Before we get into the risks, you need to understand pledging is not always risky. In the bull market, pledging shares is not a big concern. In such times, the market is moving upward, and investors are optimistic. The problem arises in the bear market.
- In the above example, if the bank sells the shares of your company, then your news will go public, and it may further decline the share price because of panic selling by the retail customers. The share price can fall drastically, and investors may lose their hard-earned money.
- As mentioned above, the shareholding pattern of the company changes when the shares are sold. It may change the voting power of the promoters as they have less share now. If the number falls significantly, promoters’ ability to make crucial decisions gets impacted.
- When a company raises funds by pledging, they usually tend to carry higher interest rates. Paying high interest will reduce the margins of the company and might affect future financial performance.
Should I avoid companies with pledged shares?
Not always. You need to understand the reason why promoters pledged shares. Also, what is the current market situation?
If it is a bull run, you can invest in companies with pledged shares where pledging happens as part of the growth plan. Companies having increasing operating cash flow and an excellent future outlook are worth considering.
Also, if you find a company where the promoters have been continuously decreasing the percent of pledged shares, then it is a positive sign for investors.
However, if the promoters have pledged over 50% of their shares, it is a red alert, and you should avoid such companies. Pledging is also a sign of low credibility (the company failed to raise funds through other channels), high debt, and poor cash flow. If the pledged shares are increasing continuously, investors should avoid investing in such companies.
We hope the article will help you in picking the right stock for your portfolio going forward. If you are unsure of what stock to buy, you can download Jarvis Invest. It is an AI-driven platform that creates your equity portfolio based on your risk profile and investment horizon. The app checks every stock on hundreds of data pointers and only suggests stocks with no red flags.