Pledged shares and stock performance – correlation versus causation

The year 2019 witnessed a spectacular collapse of business conglomerate that was once considered very savvy. The share prices of its flagship companies have fallen as much 99% from their all-time highs, even culminating in a bankruptcy in just the last year. A common string across these companies was that the promoters had pledged a large percentage of their shareholding.

A common fallacy in investing is that ‘Great companies almost always make for great investments.’ We easily forget that Hindustan Uniliver, a great company, was not a great investment for the entire decade ending 2010. Recency bias is the phenomenon that people easily remember something that happened recently, compared to something that occurred a while back.

That seems to be at play when one looks at the stock performance of a few companies where promoter shares are heavily pledged. Despite the analysts’ increasing their expectation of forward earnings over the last one year, the stocks in the table below have fallen between 16% and 55%. These are very steep corrections, considering that the underlying businesses are not nearly as challenged as those stock prices suggest.

That brings us to an interesting concept of correlation versus causation. They don’t mean the same thing, even if they co-exist. Correlation indicates that two variables are moving in the same direction, whereas causation indicates that one event is causing the other.

For example, stock prices and promoter pledges are two different variables. In some cases, there has been a causal relationship (pledged shares have been sold in secondary markets which has led to lower share price), but there is no reason why they should be correlated (that is, share prices should not continue to fall just because promoter pledges stay high).
 

 
Disclosures

Information in this blogpost is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI.

Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Buoyant Capital may have/have had holdings in the stocks at mentioned in this blogpost at different points in time.

Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.

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