Collateral damage

The frequent bouts of market surge and fall are turning investors and companies risk-averse and will lead to political instability

By Mohan Sule

While tabulating the gain or loss of investors’ wealth following a sharp surge or a steep slide in market capitalisation, what is often missed is the unseen benefit or damage of the market’s sudden upturn or downturn. In a bear phase, investors shy off even from stocks available at attractive valuations and companies concentrate on maintaining liquidity and meeting working capital needs to keep operations running. This behavior was as predictable as the periodic market cycles. After the Great Depression of 1930s, when the stock market crash in the US in October 1929 triggered a decade-long recession round the world, the alternate swings in the market were fairly routine, with long bull phases mixed with short bouts of recession. The US basked in a bull phase for the entire 1990s. The interruption by the dot-com bust at the turn of the century lasted for about three years before the liquidity-fuelled market took stocks to historic highs. This familiar comfortable cycle got disrupted in 2008, when the mortgage bubble busted. It required the collapse of Lehman Brothers for the realisation of the downside of globalisation. The loose money policy followed by countries hurt by exposure to real estate debt resulted in flight of capital to high-growth areas rather than being ploughed into their domestic economy, hitting domestic job creation. The gusher of forex inflow bolstered currencies of developing countries, blunting the competitiveness of local enterprises and at the same time boosting the cost of inputs, fuelling inflation. Simultaneously, the unwillingness or inability of the US and many European economies to either cut spending or raise taxes ballooned their debts, culminating in a showdown in the US, with President Obama forced to agree to cut spending without any tax increases as a price to increase the debt ceiling.

Yet, after the initial panic following the downgrading of the US’s credit rating, markets calmed, taking comfort from history. Soon after the meltdown three years ago, monetary authorities around the world printed money to make available credit to industry. Governments offered tax concessions to individuals as well as companies. This time, too, the expectation is that the US Federal Reserve will undertake a third round of quantitative easing by buying bonds from the market. Will history repeat? There are some differences. First is the limited breathing space for governments, especially in the US and Europe, to announce fiscal stimulus due to their huge debt. Central banks will have to shoulder the burden of revving up the economy. Many monetary agencies in the emergencies economies are handicapped due to inflation stubbornly appending their growth as more and more of the population is lifted above poverty. Their hope lies in the market meltdown pulling down prices of agri commodities, base metals and energy. Going by past experience, their expectation may be short-lived as speculators go long on these commodities in anticipation of a bounce-back on renewed consumption by emerging economies. For developed countries, these export markets could provide an opportunity to revive their home economies. So like the 2008, when panic gave way to optimism in bust a year’s time — the recession in the US was officially declared over in 2009 — this time too the global economy could spring back sooner than expected.

At the same time, the short spells of boom and bust could permanently change the way investors and companies manage their money. Besides turning with a vengeance to unproductive assets like gold, only those with a horizon of three to five years may turn to equities. This means markets may witness short spells of intense volatility and trade range-bound for protracted periods, thereby reducing chances of quick gains. Uncertain about future direction, investors will increasingly turn to derivatives to hedge their downsides, thereby sucking volumes from the cash market. For companies, even a quarter will be too long to give guidance as markets change their complexion in days. As a result, the tendency will be to hoard cash rather than pay out dividends and become cautious while embarking on capacity expansion or acquisitions, unsure what the landscape will offer two or three years hence. On the flip side, competitors will be forced to share some services or merge to survive rather than to grow. Cost-cutting will become a recurring theme rather than a means resorted during a slowdown. The casualty will be job creation, leading to political instability around the world. The Arab spring; riots in London; the unrest in Israel, Greece, and Spain; the disgust over corruption in India; and the outrage over the high-speed train accident in China are signs of things to come.

Mohan Sule

Pledging shares

Promoters intending to use their holdings as collateral should offer ordinary shareholders the right of first refusal

By Mohan Sule

A market reeling under negative news is ready to believe the worst of companies whose promoters have used their stake to raise funds. The issue of pledged shares had flared up first during the downturn following the global economic meltdown of 2008-09, when promoter Ramalinga Raju was found to have borrowed against his holdings in Satyam Computer Services. One company even changed hands on the failure of the promoter, who had used his entire stake in the company as collateral, to buy back the shares. Pledging shares against loans is not the exclusive practice of promoters. Even small investors use their portfolio to meet emergency needs or as a leverage to make further investments. The problem starts when the market begins its slide, depreciating the value of the pledged shares. Earlier, small investors had no way of knowing about these off-market deals till Sebi late January 2009 ordered disclosure from companies whose promoters had pledged more than 25,000 shares or 1% of the company’s equity, whichever is less, in a quarter. Instead of calming the market, the move towards transparency has made matters worse. There is stampede to liquidate stocks whose promoters have pledged shares. So promoters face a dilemma. If they pledge shares to meet working capital requirement, a common reason, the revelation defies the purpose as the value of the collateral undergoes a rapid slide, thereby making the task difficult. Promoters who want to pledge their holdings to raise funds for consolidation of their ownership or acquisitions may find the tables turned: from being hunters they become preys. The lender may sell the shares even to competitors to get a good price though their market price may have eroded substantially post disclosure.

The irony is that most promoters pledge their shares during a bull run rather than a bearish phase. Getting a good price is part of the reason. This is the time when they need funds to undertake expansion or diversify. Going through organised channels is time consuming, requiring subjecting their companies to due diligence. Or the institution may have exhausted the sector quota. Besides, too much loan skews the debt-equity ratio and makes the company vulnerable to swings in interest rates, going forward. Issuing fresh equity leads to dilution of earning, especially for long gestation projects, as well as controlling stake. Instead, pledging of shares can be quick. For the lender the upside is that instead of holding stocks that may turn dud when the bull bubble is pricked, he can make a neat profit from the pledged shares by selling them to rivals. This is what happened in the case of Great Offshore. But this is a lose-lose situation for the retail investors. First, the news itself creates panic in the belief that the promoter is in trouble. Not all promoters pledge their shares for official reasons. They may need funds in their personal capacity. Many small investors take exposure to a company because of the comfortable promoter holding. According to market wisdom, higher the promoter holding, greater is his commitment to the company. The prospect of the promoter losing his grip, therefore, is worrisome for these investors. Reduction in their equity can also curb promoters’ decision- making and execution prowess.

In view of the unease of ordinary investors, promoters of late are opting for private placement, thereby setting a benchmark price for the stock. This route also bolsters investor confidence in the company. Those investors worrying about earning dilution get an opportunity to exit at a premium. A follow-on offer or a rights issue allows investors to take fresh exposure, invariably at a discount. The lower price also acts as a floor for those who want to quit. Though a burden, debt is seen necessary for capital-intensive companies to grow business. At least there would be some long-term gain, goes the logic. Pledging of shares signifies loss of confidence by institutional investors and lenders in the promoter or in the reasons for mopping the resources. The market views it as an act of selfishness of the promoter, who wants to maintain his holding and, at the same time, raise money. It also means existing shareholders have to gear for a free fall in the stock’s price soon after the disclosure. Only a hostile takeover can reverse the course. Making promoters to go public of their pledged holdings is a welcome but just the first step in protecting ordinary shareholders’ interest. Sebi must now make it mandatory for promoters to give ordinary shareholders the right of first refusal. The offer, at about prevalent market price, should come with a call option. Failure to redeem could give strategic investors or competitors an opportunity to bid for the shares. This would ensure a safety net as well as boost valuations in the long run. Not only promoters, even ordinary shareholders would be in a win-win situation.

Mohan Sule