Mark to market | Creating a penny stock bubble

Mark to market | Creating a penny stock bubble

Retail investors in India are up to some daredevilry, buying low-quality penny stocks at a time when demand for emerging market equities has gradually been waning.

Large-cap stocks, with a market cap of more than Rs25,000 crore, have lost 8.6% in value between 14 and 22 November. But penny stocks with a market capitalization of less than Rs50 crore have risen by nearly 5% during the same period. The mid-cap and small-cap indices of the Bombay Stock Exchange (BSE) have been indicating that investor interest has shifted away from large-cap stocks lately.

This was simply because of the lack of buying from foreign institutional investors (FIIs)—some of them have, in fact, been exiting. FIIs typically invest in large-caps and large-sized mid-caps. But it’s important that even the stocks comprising the BSE small-cap index have an average market capitalization of Rs550 crore, just 12% of them with a value of less than Rs200 crore. ­Institutional investors, including some FIIs, have some stake in them.

Such stocks have risen by less than 2% since 14 November. The worrying trend is that stocks with the lowest market capitalization, where institutional interest is practically non-existent, are the ones that are rising the fastest. Such shares are shunned by institutional investors because of low liquidity, corporate governance issues and poor financial performance.

A Mint analysis of corporate results for the first six months of the current fiscal reveals that the net profit of such firms dropped by more than 50% because of rising interest costs, raw material costs inflation and the appreciation of the rupee.

Larger-sized firms saw a drop in profit growth rates over the previous year, but continued to report a year-on-year increase of about 18-20%. Penny stocks, which are companies with a market capitalization of less than Rs50 crore, had the rare distinction of reporting a drop in profit.

Given this backdrop, the rise in penny stocks lately is a worrying sign.

On Friday, a large number of such stocks were stuck on the upper circuit on BSE. Interestingly, an almost equally large number of shares were at the other end of the circuit filter, providing a grim reminder that these shares often don’t provide investors an opportunity to even exit.

Pantaloon on a high

Shares of Pantaloon Retail (India) Ltd rose more than 3% on Friday because of a news report that one of the company’s subsidiaries was valued at $1billion (Rs3,960 crore) based on a pre-initial public offering (IPO) transaction. Future Capital Holdings’ reported valuation essentially means that Pantaloon’s 61% stake in the company is worth more than Rs2,400 crore. The entire firm is valued at Rs9,900 crore, which means Future Capital alone accounts for almost one-fourth of the firm’s value.

At current levels, Pantaloon shares are just 3.4% away from their all-time closing high of Rs683. In the special FII-FII trade segment, Pantaloon recently traded about 26% higher than the price on the National Stock Exchange—since the FII limit on the shares has been hit, foreign institutions can purchase Pantaloon shares only from another FII. Some other scrips in the retail segment, on the other hand, are not very far from their 52-week lows. The retail business clearly isn’t the reason Pantaloon’s shares are a hit. On the contrary, the company’s same-store sales have been under pressure owing to competition in the core value retailing segment. Same-store sales fell as much 25% in October.

The company’s strategy of floating subsidiaries and then unlocking value in them through IPOs and private placements is the reason investors are flocking the counter. The reported deal for shares in Future Capital Holdings just makes sure that the unlocking theory is playing out as investors had hoped.

Pantaloon recently also announced its plans to float another subsidiary company, Future Ventures Ltd—a new venture capital company. But even adjusted for the reported valuation of Future Capital, Pantaloon’s retail business is valued at around 100 times, trailing earnings after adjusting for gains from sale of investments last year.

The valuation of other subsidiaries are not expected to be substantial, which means the implied valuation of the retail business continues to be rather high.

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