The Reality Behind Promoter Holdings & Pledged Shares

Too often investing legends like Warren Buffett, Benjamin Franklin and others have regarded successful investing as an art of discovering fundamentally sound stocks. So, one of the important elements within the checklist of fundamentally sound stocks is to analyze the promoter holding pattern of that stock.

Unfortunately, promoter holding analysis is one of the most underrated metrics when it comes to the number of investors analyzing it to form an opinion about the stock; however, this metric has deep-rooted impacts during the overall investment horizon of an investor.

Let’s simplify it together and understand what promoter holding and its pledging are!

What is Promoters Holding?

Promoters holding signifies the ownership percentage (percentage of shares held out of total equity capital) by the promoters of a company. Promoters usually have a preponderance of stake (majority of holding and control) in the company, hence it becomes of paramount importance to keep a track of promoter holding in any company. Even the industry regulator, SEBI, mandates all the promoters of listed companies, under its regulations 31(1) and (2), to disclose their holding pattern, and any encumbrances made and any encumbrances discharged within 7 days from such creation or discharge.

Are we done? No, we aren’t. Merely keeping a track of promoter holdings is like a drop in a bucket. Tracking promoter holdings should be accompanied by tracking the pledged proportion of those holdings. Solely scouting out a high promoter holding stock after arriving at a consensus that it’s a fundamentally strong stock, is too good a story to be believed.

Promoters Share Pledging

During unprecedented times or when the promoters are in need of funds, they may approach banks and financial institutions to offer them loans, where they may propose to mortgage their shares as collateral. This, in financial terms, is referred to as ‘Pledging of Shares’. It is a legal and widely practised method to finance the needs of funds of the promoters.

SEBI records state that, out of 5000 companies that are listed in BSE, around 4274 companies had promoter pledging, thus analyzing that pledging of promoter holdings is the long end of the stick to arrive at a fundamentally sound stock in terms of promoter holdings. Let’s prove this fact further using Ticker screener.

How to find high promoters pledged companies?

We used a query that instructed Ticker screener to populate all the companies currently having a promoter pledging greater than 99.9%. It can be seen in the above image that 47 such companies come in the list of having promoter pledging greater than 99.9%; hence if someone would have analyzed such companies based upon just their promoter holdings (and not considered the pledge), they would have ended up portraying an entirely delusive picture.

But why is promoters' pledging considered a sin?

01. Financials in a difficult place

Companies whose financial health is deteriorating quarter after quarter are generally the ones that have higher promoter pledging, which further is correlated with the fact that the promoters have lost faith in their company and hence stock prices start tumbling. In the above image, it can be noticed that 7 out of the 8 companies had a return on equity of less than 5%. Hence promoters may either choose to reduce their holdings or else, they may have to pledge these shares in order to meet their contingencies.

02. Last arrow in the quiver

Time and again, companies need funds for multiple reasons, including routine operational expenses and funds for expansion purposes being two of the many other reasons. To finance such needs, companies may opt to take loans from banks and other financial institutions. Generally, banks and financial institutions hesitate to fund such companies without collateral because of their poor health (as explained in the bullet point above). Hence,if such companies have to raise finances, the only option left with them is to pledge the holdings of their promoters as a mortgage. This generally generates a negative impression in the mind of the investors.

03. The chain effects

In the best interest of banks, financial institutions, and largely of the economy, RBI has laid down a norm in corporate credit appraisal that banks can fund a maximum of up to 50% of the value of the promoters’ portfolio that is being pledged. To give it a numeric connotation, every ₹1 raised as a loan would require ₹2 worth of shares to be pledged.

Thus, when the market price of the shares fall (which is reasonably certain after pledging happens), banks have to call the promoters to pledge additional shares; or in case of non-compliance, sell off the pledged shares to make up for the value of the collateral. This gives rise to a chain effect of rippling stock prices which in itself becomes a perilous situation, especially for conservative or low-risk appetite investors.

04. History has a habit of repeating itself

There have been evident incidences in the lights of Yes Bank, DHFL, Reliance ADAG, being few amongst many others, where in the past, these companies have had a high promoter pledging and where the promoters were unable to discharge their obligations on time, due to which the wealth of common investors eroded. History has a habit of repeating itself. Hence, a rational investor should stay away from stocks having high promoter pledging and further from those whose financial health is distressed in terms of low operating revenues, return on equity and operating profit growth.

Now that we have got hindsight of the ill effects of promoter pledging, let us put forward a question- Is promoter pledging always bad? Does it give a clear picture that the stock is in bad shape?

Nah! Not necessarily.

Is promoters' pledging always bad?

There have been incidents in the past where companies opted for promoter pledging and after a certain period of time, they have discharged their liabilities to release the charge that was created on their shares. During this phase, the lost leap of faith rebounds, and thus stock prices tend to rise (reflect their fair value).

To put forward an example, one can consider evaluating JSW Steel which has successfully discharged its pledge of promoter holdings and the stock has performed well since that.

(Source of data: Ticker)

If you wish to see the promoters pledging of other companies in your watchlist, all that you need to do is visit Ticker, type the name of the company in the search box, and visit the shareholding section to have a summarized description of the entire scenario revolving around promoter holdings & pledging.

Also, if you wish to screen high promoters pledging companies that you need to be careful of, you can use the procedure we used and come up with a list as you saw in the beginning of this article. Just visit the Screener section on Ticker. Run the screener & type the query as “Promoter Pledging Q5 > 99.9”. Blink your eye, and you have it!

Summing it up

The crux of the matter is that for an analysis to be highly effective, it is imperative to study promoter holdings and promoter pledging in consensus. High promoter pledging is an alarming signal; however, it may not necessarily be a negative signal for the stock. You must be aware that in financial markets there are false alarms as well.

High promoter holdings with reasonable promoter pledging could be a win-win for both the company, as well as the investors.

On the contrary, a promoter defaulting on the loan on which their holdings are pledged, is a red flag for investors, indicating that now may be the right time to exit.

Invest carefully!

*Disclaimer: This should not be construed as investment advice. Invest only after proper research.