Free float – The X factor in stock returns  

As investors, we often wonder why stocks that we own in our portfolios are moving so slowly, while others out in the market are behaving like Diwali rockets. This can happen irrespective of the fundamentals or valuations for our shares being superior.

This could happen because of the many non-fundamental factors that propel stock prices. Knowing what they are and understanding how they can work for or against you, can make you a more successful investor. In this article, we’ll talk about free float – a critical X factor in stock returns.

What’s free float

A unique feature of Indian companies is a high proportion of equity held by promoters. A ‘promoter’ is a member of the business family or a founder who started the business, and hangs on to a big chunk of shares in the company even after it is listed. Despite attempts by regulators to loosen their stranglehold, Indian promoters continue to hold sizeable stakes. In March 2024, promoters held about 51% of all the outstanding shares by value and 55% by volume across NSE-listed companies. 

Promoters typically do not liquidate their shares in a hurry because majority ownership gives them the right to appoint top honchos, have a say in the constitution of the Board, decide on major corporate actions and generally call the shots in the day-to-day running of the business.

Therefore, only the shares that the promoters don’t hold are freely available for other investors. This is what gives rise to the concept of free float. Free float refers to the outstanding shares in a company that can be bought or sold by public investors. For example, Patanjali Foods has a Rs 72 crore equity base, with promoters owning a 73.77% stake in the company. Its free float is thus Rs 18.8 crore – or the remaining 26.23% of its outstanding equity.

Securities Exchange Board of India (SEBI) regulations require all listed companies to have a minimum free float of 25%. Promoters of companies which breach the 75% threshold are expected to bring it back down to 75% through sale of shares, public offers, offers for sale or other means. There are however exemptions to this rule. Companies that have recently launched IPOs or PSUs that have recently been divested, can continue with low free float for a few years.

A stock screener on PrimeInvestor shows that of the 2312 listed companies for which data was available, nearly 130 featured promoter stakes of 75% or more and 66 companies featured promoter stakes of 85% plus. Some of the known names in the 85% plus club are IRFC, Madras Fertilisers, LIC, Indian Overseas Bank, Viceroy Hotels, Tantia Constructions, UCO Bank, IDBI Bank, FACT, MMTC, Adani Wilmar and ITDC.

Investors looking to avoid the pitfalls of low free float should ideally restrict their universe to companies with a 75% or lower promoter holding. Percentages apart, absolute free float – or the value of shares available to the public – is also an important factor. Stocks with absolute free float less than Rs 100 crore are avoidable for retail investors. 

Why float matters

If you’re a fan of Nicholas Taleb, you’d know the benefits of ‘skin in the game’. Many investors like to buy companies with high promoter holdings because they believe that with a significant personal stake in the venture, the promoter will be less inclined to short-change public shareholders or jeopardise the interests of business.

But while a promoter stake of say upto 75% is good for ‘skin-in-the-game’ reasons, excessive promoter stakes that lead to low free float can be quite bad for public investors.

Shot at index inclusion

Retail investors often like to own stocks that stand a chance of making it to the big league. The big league by definition means a stock that can be included in frontline indices. With index funds and ETFs being the flavour of the market, a stock’s inclusion into an index automatically draws more flows into it, and guarantees better valuations. Global institutional money, including that of pension funds and educational trusts, flows more into passive than active funds.

In India, stocks are chosen for inclusion in indices such as the Nifty50, Sensex30, Nifty100, Nifty Next 50, Nifty Midcap 150 etc based on their free float market capitalisation. These indices decide to include new stocks or exclude old ones by market capitalisation, adjusted for the free float factor, in effect the stock available to the public.   

The free float filter explains why LIC, despite its market cap of Rs 4.17 lakh crore does not yet figure in the Nifty50, while its tinier rival SBI Life with a Rs 1.3 lakh crore market cap does. With a promoter holding of 96.5%, LIC’s free float is a fraction of its mammoth market cap. That brings us to the first reason for going after healthy free-float stocks – such stocks stand a better chance of making it to the indices.  

Institutional interest

Sensible retail investors like to seek safety in numbers. When adding a stock to their portfolio, they like to see the presence of institutions such as mutual funds, insurers, foreign funds and so on. But for institutions to seriously consider owning a stock, it needs sufficient free float to absorb their large buy or sell orders without undue price swings. Stocks with low free float often carry high impact costs, which eat into returns for institutional investors. Investing in low free float stocks thus deprives you of the comfort of healthy institutional holdings.

Liquidity and trading activity

Direct stock investing entails entering a stock at the right price, building material positions in it at good valuations and exiting it, when the price factors in the positives. But low free float can be constraint to executing all of this. Market orders in stocks with low free float tend to get executed at prices that are way off the quoted price that you see on the screen.

This is because the last traded price for such stocks will be based on thin volumes. Building a sizeable position in a low float stock for your portfolio can be a tricky affair. To do this, you may need to place limit orders and phase out your buys or sells over multiple sessions. If prices move materially in the interim, that’s a lost opportunity on returns.

Thanks to supply constraints, low float stocks can also trade at valuations that are totally out of whack with their fundamentals and peers. The PE of 275 times for Adani Wilmar, 98 for ITDC, 125 times for Viceroy Hotels, 360 for Diamond Power Infra, 168 for FACT, 83 for MMTC, are examples of this phenomenon.

Unwitting investors who enter such stocks believing that their valuations reflect stellar prospects, may be in for a rude shock in the long run, if the float expands or promoters decide to make hay while the sun shines by selling their stakes.

Low-float PSUs have been particularly susceptible to this risk. After starting off at stellar PEs due to the float factor, their prices tank and PEs de-rate every time the government announces a new tranche of divestment that adds to the float.  

Governance risks

One of the biggest wild card factors in equity investing is governance risks. Stocks with low free float are more susceptible to these risks. In India, promoters have the knack of calling the shots on company fortunes and actions even without owning controlling equity stakes. When they own stakes that go far beyond a simple majority, you can only imagine the kind of deals they can push through that are inimical to minority shareholders.

Low float often gives promoters carte blanche to run listed companies with opaque operations, multi-layer structures, a web of subsidiaries and related party transactions including generous royalty payouts, all of which come at the expense of public shareholders. Moreover, with voting rights overwhelmingly in the hands of promoters, there’s precious little that investors can do to vote out such practices.

Float games

Higher institutional participation and diverse market participants have made it tougher for operators to rig up the prices of listed stocks in recent years. But with their low institutional participation and limited shares, low-float companies can be exceptions to this rule.

In the ongoing bull market, low float stocks have been a happy playground for operators of all hues. Limited float makes it easy for operators to corner a chunk of the available equity, float fanciful narratives and bid up an unremarkable company’s valuation to the stratosphere.

Even if the promoters of low-float companies happen to be genuine, actions of other investors can make these stocks highly risky. High net worth investors or market cartels can mop up the float, so that prices climb vertically even with limited buying interest. 

Sometimes, institutions such as mutual funds enter these float games. Some mutual funds and portfolio managers have been known to corner large positions in low-float stocks. As the prices move up disproportionately to fundamentals, their NAVs rise. This ‘performance’ is then showcased to attract new investors and flows. Deploying the new money in the same low-float candidates can keep the whole party going for a while.

Of course, should a bear market or other event arrive to interrupt those flows and trigger redemptions, liquidity can dry up in a trice. In such cases, impact costs play out in the reverse with the prices of their holdings falling off a cliff in response to even limited sell orders.

All this adds to the reasons for retail investors to pay special attention to a stock’s public float, before giving it serious consideration as a portfolio candidate.