Pledged shares

icicidirect has come out with awrite upon pledged shares. I hope it will be useful for some.

Pledging of share is the deadliest of all diseases that has plagued indian share market.

When a promoter pledge some of his share, way too many underlying assumptions on valuing a stock goes for a toss. This makes stocks/business in a complex derivative like of situation. Things starts behaving in inverted way.

Fundamental analysis tells us that, when stocks price fall, stocks becomes much more attractive and more buyer flock to but more of the same stock, thereby stabilizing the price to a equilibrium price. Share pledging requires some of the participants to force sell share as the stocks goes down, thereby reducing stocks with share pledging unsuited for fundamental analysis.

Value investing takes advantage of undervaluation of stocks, and possibility of stock reaching fair-valuation stage in future. Investing is pledged share stock is like investing in a fairly valued (actually very very overvalued if you consider the hidden illiquidity) with high chance of it going to a fundamentally high undervaluation stage. So investing in pledged share is anti-value investing.

Ability to exit a stock without much issue, or effecting the price is one of the often-ignored parameter in stock investing. Liquidity is another name for the same. That is why illiquid stocks tends to have a lower valuation as compared to liquid stocks. This delta is valuation is called illiquidity premium, and is as important as other risk premium value investor ask for a stock. Investing in stock with share pledging is a case of assured super-high liquidity in future. This is what I call hidden illiquidity of pledged share stocks. As it is a super case, one need to ask a steep premium for it.

To me stocks with pledged share, are avoid at all cost stock. There might be few exception like Ajanta (6% of promoter shares are pledged), but in general make sense to stay away from such stocks.

Actually, pledging of shares with banks, as secondary collateral (primary collateral being plants & machinery) is sometimes unavoidable.

But stock market entities are on the lookout for spreading rumours in such stocks. So such stocks are particularly vulnerable when we are in a bear phase, as seems to be on in last month. Sometimes without even 1 pledged share being offloaded, just a rumour that a financier may sell can cause a stock to hit lower circuits. And once there is a scare, it perpetuates itself, as panicky investors offload.

So i too would tend to agree that we should be careful about such stocks & if holding, track them very closely for 1st signs of new/rumour.