The Unintended Consequences of the 1Kobo Stock Rule

Proshare

 

Thursday, October 22, 2015 11.18PM / FDC
 

The Nigerian Stock Exchange was set to change in August with the introduction of the 1 kobo stock rule. By removing the 50 kobo price floor, the new rule was supposed to boost liquidity and investor confidence, as well as bring the Nigerian Stock Exchange (NSE) more in line with advanced trading markets, which have no price restrictions. However, on July 21, 2015 the implementation of the new rule was suspended indefinitely citing fears that it would further impair an already declining market capitalization.
 

The cold feet are understandable. The NSE All Shares Index (ASI) has recorded an 11.31% loss since January amidst political uncertainty, declining oil prices, and delays in policy formulation follow-ing the election of the new administration. The new rule would likely cause a further decline resulting in severe consequences for the broader economy. Companies would likely see their market values plummet, with declines as high as 50% being a very real possibility. If market capitalizations fell below the minimum requirement, affected companies would have to seek other means of raising funds to meet their capital requirements.
 

Despite the anticipated negative consequences, however, the pol-icy is an overdue market reform. It would contribute to market liquidity and also reflect the true value of some dormant stocks trading at nominal value on the exchange thereby promoting mar-ket efficiency. This will go a long way in bringing the market to par with other advanced markets making it more attractive to foreign portfolio investors and eventually increasing market size and liquidity. These benefits outweigh the temporary pain of a reduction in stock prices and market value, as a strong market is foundational for a strong and growing economy.
 

However, It is the timing and mode of implementation that will determine if it will be successful or otherwise. The NSE must work with the Securities and Exchange Commission SEC to synchronize the implementation of the policy with a strong market rally. While some level of pain is inevitable, effective collaboration on implementation would cushion the negative impact on investors and the entire market, while achieving the benefits outlined above.

Understanding the 50 kobo floor price

The current 50 kobo price floor was introduced following the 2008 market crash. The change was made to minimize the magnitude of losses and salvage crashing stocks that were headed for 1 kobo. In effect the price floor of 50 kobo reduced the loss exposure of individual investors and the entire stock market.
 

Following the crash, risk management frameworks for commercial banks were improved, decreasing the exposure of the financial system to the banks. As a result, the factors that led to the collapse of the market have been addressed. Yet the 50 kobo price floor has remained, acting as a support for stocks which otherwise would have dropped further. It is in this context that the 1 kobo rule was conceived.
 

Likely implications of the 1 kobo rule

There is no denying that the negative impacts of the 1 kobo rule would be far reaching. It would likely impact entire sectors, mergers and acquisitions, bank loans, penny stocks, and IPOs.
 

Sectors that have seen little movement from the 50 kobo mark would be the hardest hit. One example would be the insurance sector. Twenty-two of its stocks have remained at the 50 kobo floor price since 2008 and the industry has all but lost national investor confidence as a result. In other sectors, such as industrials and ICT the inability for companies to increase their stock from 50 kobo could result in hostile takeovers and the rise of the cartel behavior.
 

On the loans front, there could be a significant increase in margin calls by commercial banks. Asset quality deterioration by companies whose stocks have been pledged as collateral would lead to lenders calling for extra collateral to reduce or avoid credit expo-sure. If the companies are unable to provide extra collateral, then we might see an increase in the impairments and non-performing loans, which will ultimately affect the banks’ profitability.
 

For individual and portfolio investors who trade primarily in penny stocks, the danger of portfolio value erosion is even more pronounced. Whilst the 1 kobo rule will give them the opportunity of  exiting positions in illiquid stocks, it also exposes them to major losses as they reassess their value after the selloff.
 

Companies preparing to embark on initial public offerings (IPOs) may have to list at a lower price per share. This means they will have to increase their outstanding shares to meet up with the capital that they seek to raise. This also means that registrars will have a lot more shares to reconcile and reconciliation will probably become more cumbersome.
 

Concerns about companies being delisted from the exchange have also been raised from different quarters. When a stock price falls to 1 kobo with little or no trading activity on the stock, there is a probability of it being delisted from the exchange. The SEC has constantly reiterated its commitment to support companies enlisting on the exchange and exploiting the inherent opportunities that the bourse has to offer. The move to implement the 1 kobo rule may contradict this effort.
 

The Way Forward

Without a doubt, the impacts of the 1 kobo rule are severe and varied. However, the importance of the 1 kobo rule cannot be downplayed. When implemented, it would bring about the much-needed liquidity in the stock market. Investors who have investments trapped in non-performing stocks would be able to sell them off when the stocks find their true value. This would come at some cost but would be much more preferable to having assets that cannot be traded because they are overpriced.
 

Market turn-over will also increase, as more investors will be willing to trade knowing that price floors won’t serve as barriers when they desire to exit the market.
 

In the short term, the fall in stock prices will bring about in-creased market activities, as more Nigerians and foreign portfolio investors will be willing and able to trade on the exchange as stock prices fall, bringing liquidity, increased trade volumes and eventually market capitalization. Listed companies will be able to raise more capital from the exchange stimulating economic activities.
 

Long-term benefits will include improved market efficiency: in-creased responsiveness of stock prices to market news and companies periodic results. Companies listed on the exchange will make every attempt to improve financial performance knowing fully well that poor results will reflect on their stock prices and make them susceptible to hostile takeovers and acquisitions.
 

Furthermore, when the rule is implemented, stocks currently trading at 50 Kobo will find their true value; more investors will be able to increase their holdings in firms where the ownership structure is uneven. This is turn will increase their influence and voting rights and may bring about increased responsibility by the board of directors.
 

Investor confidence will be bolstered on improved market transparency, as will the perception of international market players to the market. Increased demand for cheap stocks will improve market turnover and stock prices will be set by market forces as against artificial support.
 

The benefits of the 1 kobo rule cannot be overstated. Overall, ad-vantages of this rule to the economy, the exchange, listed companies and investors will outweigh its disadvantages despite initial pains.
 

The timing of the implementation however is just as important as the rule itself. For a while now, the market performance has been unimpressive which is why the implementation of the rule was suspended, It is best that the price floors are gradually reduced from 50 kobo to, say, 30 kobo and that market performance is carefully watched before the price floor is further reduced or totally removed. A gradual reduction will help to gauge the market response and allow time to formulate appropriate response measures to the precise challenges that arise.
 

Conclusion

Whilst the SEC may have good intentions with the formulation of this policy, it is in the best interest of the NSE that this policy has now been suspended. Proper research needs to be carried out and all factors taken into consideration before recommendations are made as to how the above listed issues can be addressed and the rule implemented. The net negative effects of this policy could very well outweigh its positive effects if implemented at the wrong time and using the wrong approach.
 

The rule, which has been temporarily suspended due to the depressed nature of the exchange, will become effective at some time in the future. However, there is no perfect time. Whenever the NSE does implement the rule, the market will react and the consequences enumerated above will play out. Whilst not a populist reform, it is one that will bring about the much needed transparency on the exchange and force companies whose stocks are currently trading at 50k to do more work so that they do not lose out of the market.

 

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