The warning signal in latest Promoter Pledging data

Apr 28, 2014

In this issue:
» India Inc. benefitting from land sales
» RGESS scheme fails to woo investors
» IMF flags off the risk of high corporate debt in India
» It's time Asian economies undertake structural changes
» ...and more!

The earning season is here now. And along with the quarterly performance, the companies have crucial information to reveal. We are here referring to the shareholding pattern and most importantly, the promoters' share pledging. Going by the latest disclosure, retail investors have reasons to be concerned. As per an article in Indian express, 345 of BSE 500 companies have released shareholding data. And guess what? The share of promoter pledged shares has touched all time high of 10%.

Before we discuss why investors should be bothered, let us first dig into the reasons for pledging. Promoters may pledge shares to raise funds from banks or NBFCs for company's growth, such as acquisition, capacity expansion or to finance new project. The pledged shares act as collateral for the borrowed funds. Or it could be collateral against a medium term loan taken for the company, for e.g. working capital loan. In some cases, the promoters pledge shares when valuations are high to borrow funds at low rates to meet personal needs or to invest in unrelated investments such as realty etc. At times, pledging could be a part of corporate debt restructuring (CDR) process, where lenders use it to ensure that promoters stick to the new restructuring terms. In short, pledging by itself is not illegal or bad. The motive is wide ranging, and the intentions could be noble or wily.

But what could explain the rise in promoter pledging in current times? Desperate times lead to desperate measures we believe. In the times of liquidity crunch, slowdown in the project clearances and rising inflation leading to high input prices there are cases when the reasons behind pledging are genuine. However, even in such cases, the investors need to be watchful of how these funds are being used.

Given the risks associated with pledging, the regulators need to ensure that the interests of the minority shareholders are protected. It was after Satyam scam that SEBI woke up to need of making pledging disclosure mandatory. However, the move is incomplete unless investors get elaborate details of the quantum of funds borrowed, the end use of the money for which the shares are pledged and debt levels at regular intervals. We hope SEBI won't wait for another scam to resurface before making such disclosures a norm.

Until then, we would suggest investors to be very cautious with respect to management quality. When you are choosing a stock that has promoter stake pledged, get into the details of pledging. Companies that are over leveraged and where high percentage of shares is pledged could be a value trap for retail investors. Hence, avoid companies with high pledging, dubious management quality and high leverage ratios, no matter how attractive the valuations appear.

Do you think share pledging is an important criterion to look at while investing? Do you think there should be cap on proportion of promoters' shares that could be pledged? Let us know in the Equitymaster Club or share your comments below.

Editor's Note: There's more to getting wealthy than investing in stocks... to learn American wealth coach & DR contributor Mark Ford's wealth building strategies check out his 11 Secrets to Building Wealth (free access).

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 Chart of the day
Is India's real estate sector going through a bubble phase? Well... that's a very debatable topic; one that has been going on for a while now. But from the looks of it, companies are looking to cash in on the opportunity at the moment. As today's chart of the day displays, there have been quite a few big deals that have occurred in the recent past. In 2014 itself, there were two large deals - both having transaction values of over Rs 11.5bn each.

Is this a good thing? Well for the companies that are selling off their land parcels, a most definite yes! In our view, an outright sale of land would be a better method as compared to the joint development model - a trend that was seen in the recent past. As funds from such sales can be ploughed back into operations, such deals would be good for companies; especially those looking to make their balance sheets leaner. As reported by the Hindu Business Line, more of such deals are expected to take place in the coming future as developers would prefer paying premiums for land parcels that are free of issues related to ownerships.

India Inc making most of the land demand in 2013-14

It was already very late by the time the government realized the problems of retail investors staying away from equity related investments. Many had earlier burnt their fingers in stocks. For others the poor performance of some mutual funds had already left a bad taste in their mouth. Thus, in order to sweeten the proposition, the government decided to offer tax benefits. The Rajiv Gandhi Equity Savings Scheme (RGESS), launched in the Union Budget of 2012, was meant to lure back retail investors to stocks and funds.

In the original form, benefits under RGESS ware available to first time equity investors. That too to someone who earned up to Rs 1 m a year and invested a maximum of Rs.50, 000 in specified RGESS eligible stocks and funds. The minimum income threshold was increased to Rs 1.2 m. Further, the scheme encouraged investors to stay invested for a period of at least 3 years. One would therefore assume that such a scheme would naturally encourage the practice of long term investing. However, it would not be wrong to say that the scheme has hardly met any success. The reasons being bureaucracy and financial illiteracy. Having to fill multiple forms to avail the tax benefit was a big dampener. Add to that the need to have a demat account and the details of the approved securities. With so many hurdles most of the eligible investors were left out. And it pains to see that with the RGESS scheme having completed two years, retail investors have hardly benefitted even while the Sensex touched new highs!

Is there any scientifically proven optimal debt to equity ratio? Well, not really but the number that can come pretty close to it is perhaps 100%. In other words, if past history is anything to go by, the moment debt starts getting higher than the equity base of a firm, investors should start turning cautious. And this is precisely why a news item in a leading daily has us worried. It highlights how about one third of the corporate debt in India is having a debt to equity ratio of more than 3 times! And the agency to flag off this warning signal is none other than the global financing agency, the IMF.

It has further pointed out how about half the corporate debt in India is on the books of companies with return on assets less than 5%. Basically, this does not even cover the interest expenses. Similarly, more than 20% debt is owed by firms with profit to interest expenses ratio being less than one. Clearly, should the economic scenario worsen further, we could well be staring at a fresh round of troubles for the Indian banking sector. For this reason alone, the sector may not be a haven for value investors as it is being made out to be.

There is a trouble brewing at Asian part of the globe. Asian economies might be caught in a storm. Hence they should gear up for the better. That's because uncertainties are under play. Firstly, the possibility of U.S. reducing its monetary stimulus will throw up challenges. This will give rise to tight liquidity conditions. Consequently Asian economies will have to face higher interest rates and erratic capital flows. Asset prices might go haywire. That's not all! Dangers of slowdown in Chinese economic growth is another big threat. Not to forget lack of effective policy measures in Japan! This will only compound the problem.

Thus, global financial conditions are not at their best. Moreover, over the years the productivity of the Asian region has decelerated. It is high time that the Asian policy makers undertake structural changes. That's exactly what the International Monetary Fund (IMF) thinks too. There is dire need for new age reforms to step-up growth and attract investments. Moreover, resolving structural issues will go a long way in boosting investor confidence, as rightly put by the global agency.

Important economic decisions when taken in haste will always backfire on the government. Take the case of royalty payments by MNCs to their parent companies. It is well known that there has been a big increase in royalty payments by MNCs. This has had an adverse impact on the interests of minority shareholders. In April 2010, the government removed the existing caps on royalty payments with retrospective effect from December 2009. This was major reason for the sharp increase in the royalty outflow. It seems that the government has now woken up. The department of Industrial Policy and Promotion (DIPP) as well as the finance ministry is looking to reintroduce the caps in the next few weeks.

The caps could have been reintroduced at any time. But no action had been taken by the government so far. Apparently, foreign investor sentiment was a higher priority for the government than the interests of minority shareholders. There is nothing wrong with the royalty payouts per se. However, there must be a check against the excess outflow of the same. Only then will retail investors be protected from the wealth transfer that happens every time the local listed MNC pays a royalty to its foreign parent.

In the meanwhile, the Indian stock markets continued to languish in the red. At the time of writing, the benchmark BSE-Sensex was down by 33 points (-0.2%). Majority of the sectoral indices led by Pharma were trading in the green while capital goods and FMCG stocks were the biggest losers. Barring Taiwan, all the Asian stock markets were trading negative with China and Indonesia being the major losers. European markets opened the day on a strong note.

 Weekend investing mantra
"Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it. " - Peter Lynch

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5 Responses to "The warning signal in latest Promoter Pledging data"


May 3, 2014

Long term impact


virendra bapna

Apr 28, 2014




Apr 28, 2014

RGESS was available for the First-time Investor only. This is the biggest drawback of the Scheme. Persons having taxable income had already Mutual Fund accounts.


Ratnakar Shetty

Apr 28, 2014

I have a simple solution for royalty payments. Government can impose a penal rate of tax on excessive royalty. For example if the royalty is
- less than 1% of tunvover income tax can be 10%
-for 1% to 2%, income tax can be 15%

For royalty in excess of 3% of turnover income tax can be 75% or 85% on the excess. This will automatically prevent abuse by MNCs



Apr 28, 2014

Present situation combined with the quality of people in the industrial sectors are highly untrust worthy. The govt also dance with them for public loot. We are highly scared even to touch the well estabilished and reputed industrial operators.

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