By Ruma Dubey

When you start selling your family gold and silver, especially when all know that you are otherwise leveraged to the hilt and are facing a tight liquidity crunch, surely it means that you have hit rock bottom, as far as your financials are concerned. That is how we view things in personal day-to-day life.

What about companies then? There are many who have borrowed to the maximum limit possible and then they have pledged almost their entire promoter stake – its like silver and gold in the family, right? If then apply the same yardstick, doesn’t it then mean that such companies are indeed in troubled times and we should stay as far away as possible? Liquidity crunch, high working capital needs and difficult macro factors have led to rising pledged shares, a nightmare for companies and shareholders.

Pledged shares are indeed an indication of the financial health of the company. More the promoters stake pledged, higher is the liquidity crunch and turbulent financials. And looks like things are getting worse on the pledge shares front. At end of FY13, the value of pledged shares reached Rs.1.4 lakh crore and this meant that one in every five company had some percentage or the other their promoters stake pledged. Edelweiss put out a report stating that at end of Q4FY13, out of 3,861 companies, promoters of 788 companies had pledged part of their holdings. Axis Capital also put out a report and it pegged the figure at $18 billion in the three months ended March 2013 — the highest since September 2011.

Take a look at the table given below – a list of companies which have the highest percentage of pledged shares. A quick look indicates that most comes from infra sector, followed by realty logistics, metals, chemicals and fertilizers. And interestingly, companies from the BFSI space have shown the sharpest decline in pledged shares.

Companies where promoters have pledged more than 25% of their shares, there is rising worry that given the low prices, the promoters might opt to sell out. When stock prices crash, promoters with pledged shares could get margin calls from the lenders with whom they have pledged shares.  Pushed into the corner, promoters have only two options – either repay a part of the loan or get more collateral by pledging more shares.  If they do either, they manage to save the day. But when they are not able to do either, the lender is then forced to dump the shares. This brings down the stock price further.

With rising interest rates, the pressure has mounted on the promoters and on the NBFCs.  NBFCs typically fund high risk but at a high interest rate.  There is worry that many promoters might not have the money to pay back the borrowed money and NBFCs might begin to sell off as their cost of funding too has gone up.

So should one take this opportunity to buy stocks of these pledged shares as they hit new lows? There is no simple “yes” or “no” answer to this. Just as everyone with the name of Ramalinga Raju is not a thief, not every company which has pledged shares is bad. There are a few factors which should help you decide. Within the pledged shares itself, look for clues of trouble – of the percentage of pledged shares has increased sequentially, then surely it means things have become worse and vice versa for percentage of pledged shares coming down. One interesting fact – DLF for all its debt, does not have a single percentage of promoters shares pledged.

And while investing always keep an eye on the size of the company. The bigger the company, the lesser are the chances of the company defaulting on paying the margin money. It is not just the size of the company but also the underlying fundamentals; nothing can be above fundamentals. And by this logic, mid cap and small cap stocks are higher risk. Promoters of many such small companies pledge shares in plenty to raise money but their chances of reneging on their commitment, in terms of paying up margin call money is higher. Pay attention to the percentage of shares pledged. Higher the stake of pledged shares, higher is the risk and vice versa. 

Catching falling knives is always dangerous; so assess before buying into these highly leveraged stocks.