Why you should be wary of stocks where promoters have pledged shares

Share pledging is at a seven year high with 58 of the BSE 200 companies reporting shares pledged by promoters. Promoters of Apollo Hospitals, GMR Infra, JSW Energy, Dish TV and Reliance Infra have pledged more than 50% of shares held by them.

While this may not appear troubling now with the stock market on an uptrend, investors should be wary of a potential fallout in the event of a deep correction in the market. This is because a slide in share prices will trigger a margin call from the lender in the form of more shares to be pledged as collateral. If the promoter obliges, the pledging as a percentage of promoter holding will go up further, weighing on stock price. If the promoters can’t oblige, the lender may dump the shares to recover money, resulting in sharp fall in price. It may lead to a management change.

The problem is exacerbated because most companies with high promoter pledging are highly leveraged with erratic cash flows. Higher promoter pledging only make shares more volatile. Experts advise caution in counters where promoter pledging has gone beyond 50% of shares held by them. Where the shares pledged as a proportion of total share capital is not high—lower than 20%—the market will be able to absorb forced selling. But if pledged holding is large, it can drag down the counter badly. The reasons for pledging matter. If it is done to get working capital, it shows commitment of the promoters towards the company. However, pledging for investing in other business or personal needs is unacceptable.