A direct copy-paste from my blog
The value of a stock with Promoter share pledging
Share pledging is the new age financial tool, deployed by promoters (along with the equally dangerous LAS, loan against share). They are good as long as everything is going fine, pretty much like driving at 200kmph in a newly build Indian expressway. Once the road started becoming bumpy, things get really interesting, as you all can imagine. That is not aim of the post. The aim is to determine at what price one should buy a stock with pledging.
**The Illiquidity Premium:- **
In value investing, we determine the intrinsic value of a stock, and buy it if is available at a discount to the intrinsic value. This difference is called margin of safety. These intrinsic value are nothing but sum of the additional returns a value investor ask for having a inferior investment option (yes, stocks are an inferior investment, see Oaktree Capital’s Jan-2009 Letter) on and above safe returns. In other word, asking for margin of safety is same as quoting suitable risk premiums for a risky asset. Hence knowing qualitative risk is the cornerstone of an investment strategy.
For an excellent business, with solid ROE, ROCE number, solid moat, zero debt, and awesome future predictability, is a quite low risk investment. Hence investor ask for near zero margin of safety for these stocks, and hence these stocks gets high PE super-valuations (say GRUH). Stocks with lesser moat, lesser ROE/ROCE, lesser growth, and lesser growth visibility do have a higher risk associated with them, and hence they get a lesser PE. Their PE rerating happens as they shows consistent growth year after year.
There is another source of risk, that people tends to miss, that is illiquidity, and this is the reason why small caps tends to have a lower PE as compared to midcap/large-cap with similar fundamental profile. Liquidity implies you can sell large quantity of stocks in a falling market, without incurring a super-huge loss. Illiquidity implies you can’t sell a large quantity of the stock without heating the lower circuit consecutive time, resulting a huge loss for you. Hence make sense to ask for higher risk margin, and lower pe for an illiquid stock.
**The Curse of Hidden Iliquidity:- **
But hey, stocks like Arshiya, Zylog, CEBBCO which crashed like anything were reasonably liquid much before the stock crash. So where does this question of illiquidity come into picture. When these stocks are liquid, the promoter have pledged good amount of stock with the financer. This implies, there is a finite chance of mass sell by the lender in some distance future, which shall create mother of illiquidity problem, and crash the stock to any level. This implies, when these stocks are liquid, there was a hidden illiquidity beast hidden inside them, which was about to come anytime in future. This is what I call the hidden illiquidity. Everyone forgot to ask the premium for this illiquidity and paid the price when it hit them.
There is no theory, no empirical way to measure the risk associated with such “hidden risk”. You don’t know when this burst will happen, how much decline the stock price will happen because of the burst, how much investor confidence it shall erode in the process, what will be the floor price, and how much it shall rise post fall, and how much time it shall take. With so much uncertainty and risk associated with stocks with significant pledging, it make sense to ask for highest margin of safety for such stock. Which implies, giving zero price for a stock with pledging. In other word stock with pledging are a strictly avoid stock. Let other have fun with it.
The Gain Loss Inconsistency:-
Fundamental purist, will still argue that even if the stock has fallen 80-90% from the top, there is a chance of revival, because the underlying intrinsic value remains the same. Well, the fact of the matter is it is not. Pledged share sell implies, decreased promoter share holding, and huge reduction in networth of the promoter, which shall result in significant psychological pressure inside the promoters head, and a chance of reduced performance of the company, a remote possibility though. But that is not the major issue.
The major issue is that loss of same magnitude tends to give us more pain as compared to happiness from same amount of profit. To add to it, we tend to remember bad things little bit more than happy moments. To add to that we tend to associate thing, so a major loss from owning a stock, will automatically create negative feeling towards the stock long after the effect. As all of the participants of the market are not so rational human being, so this shall happen to all of the market participants. Hence there will be a very high chance of market participants asking a steep risk premium for investing with companies with negative bias, the result poor valuation and languishing stock price for the stock.
This is almost the opposite of what is expected from investing in an undervaluation stock. The aim is market shall correct the temporary misconception about the stock, and give it the proper valuation. Here the stock is at correct valuation, market is going penalize the stock for the pain it has given to its participant, and hence it shall remain in a undervaluation state for good length in future.
So here again, it make no sense to put money in a “hidden illiquid” stock. I feel it is better to loose money in a casino than loosing money in these kind of stock. In casino, at least you can control how much you want to loose and get some fun out of it.
Some people believe in investing in such stock after it has fallen to 80-90% of the value. It is similar to walking in an average 4 feet deep river. You never know how much share are still pledged, and how much selling is coming in your way. At best, one can trade in such stock, with his technical analysis.