Outside shareholding and market liquidity: Indian empirical regularities

Financial Express, 31 July 2010

The Ministry of Finance is pushing all listed companies to have a significant amount of outside shareholding. Does this matter? In order to examine this question, we focus on a sample of 1262 companies traded on NSE.

Variation of stock market liquidity with size

The first question we ask is: How does liquidity of these companies vary with their size (i.e. market capitalisation)? We define liquidity as the sum of the buy impact cost and the sell impact cost at a transaction size of Rs.100,000. This measure of liquidity is the bid-offer spread which would be shown on the screen if the minimum market lot was Rs.100,000. NSE has released 100 snapshots of the limit order book for February 2010, and the median value seen across these 100 values of the spread is used for each firm.

In order to see the variation with firm size, we look at deciles by market capitalisation:

DecileSize rangeSpread (Per cent)
SmallestBelow Rs.44 croreFailure
244 to 83 crore 5.84
383 to 144 crore 3.06
4144 to 230 crore 1.70
5230 to 389 crore 1.24
6389 to 724 crore 0.90
7724 to 1380 crore0.64
81380 crore to 2850 crore 0.56
92850 crore to 6770 crore 0.30
BiggestAbove Rs.6770 crore 0.18

This shows a dramatic variation of liquidity with size. At the smallest decile, the median value across 100 timepoints cannot be computed because more than half the time, the market order for Rs.100,000 cannot be executed on either buy or sell. In other words, for companies with a market capitalisation of below Rs.44 crore rupees -- who are a full tenth of NSE traded stocks -- asking for transactions of Rs.100,000 is asking for too much.

In the 2nd decile -- companies with a market capitalisation from Rs.44 crore to Rs.83 crore -- the median spread is 5.84 per cent. In other words, a person who buys Rs.100,000 of shares and immediately turns around and sells them is poorer by 5.84 per cent on account of impact cost alone.

From here on, spreads remorselessly improve as we get to bigger firms, reaching a value of 0.18 per cent for the biggest decile of firms (i.e. the best one-tenth of the firms traded at NSE).

How size and ownership pattern interact in influencing liquidity

So size clearly matters for liquidity. But firms cannot do much about their size. What about the ownership pattern? If ownership pattern mattered to liquidity, this is something that the firm (and the securities regulator) can influence.

We define outside shareholding as the shares held by everyone other than the promoter. In the interests of simplicity, we think in terms of quartiles instead of deciles, and break the data along two dimensions: size and outside shareholding.

The overall 1262 firms get allocated into quartiles by size and outside shareholding (OS) as follows:

(Below 108 crore)108 to 389 crore 389 to 1810 croreAbove Rs.1810 crore
OS below 34.4% 527579111
34.4 - 46.2 % 95837560
46.2 - 57.2 % 80797779
OS above 57.2% 88788466

Each value here is the number of firms which fall into a given cell. The smallest quartile by outside shareholding has a threshold of 34.4% which is not far from MoF's proposed cutoff of 25%. Hence, we may think of the first row of the table as being the firms with a low public shareholding who will be affected by the new push for higher public shareholding. In this row, there are 52 small firms (with a market capitalisation of below Rs.108 crore) and 111 big firms (with a market capitalisation of above Rs.1810 crore).

Within each cell of this 4 x 4 table, we compute the median spread in February 2010:

(Below 108 crore)108 to 389 crore 389 to 1810 croreAbove Rs.1810 crore
OS below 34.4% 12.15 2.43 1.03 0.30
34.4 - 46.2 % 10.93 1.80 0.86 0.28
46.2 - 57.2 % 6.95 1.71 0.63 0.27
OS above 57.2% 6.25 1.17 0.48 0.23

This table reveals the inter-relationship of size and outside shareholding in influencing liquidity. Among the firms in the bottom quartile by size, the spread is as high as 12.15% for the firms in the bottom quartile by outside shareholding. This improves to a spread of 6.25% for firms in the same size quartile where outside shareholding is above 57.2%.

Turning to the biggest firms, the improvement in the spread is small: from 0.3% in the bottom quartile by outside shareholding to 0.23% in the top quartile by outside shareholding.

In all size quartiles, increasing the outside shareholding is associated with improved liquidity in all cells of this table. In particular, there seems to be a nice gain in going from the bottom quartile (outside shareholding of below 34.4%) to the 2nd quartile (outside shareholding between 34.4% and 46.2%).

This analysis provides the empirical backdrop for policy makers to push for larger values of outside shareholding. Stock market listing is meaningless without significant market liquidity. Financial capitalism requires an efficient market, and efficiency can only materialise when the market is liquid. The policy puzzle that India faces is that of reconfiguring policy so as to achieve the largest possible number of firms, at the smallest possible size threshold, where the spread is below values like 0.5% or 1%. Only the best 500 odd firms of India presently have this privilege.

The interests of firms are also aligned with this goal. Other things being equal, firm valuation tends to improve when the stock becomes more liquid. Hence, shareholders stand to gain when the ownership structure is modified in a way that increases liquidity. In this sense, the interests of the CEO and the CFO are aligned with the interest of the government.

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