DEBATE on lack of share free float and the need to increase it has been going on in the capital market for some time. However, meaningful progress on defining and measuring free float has not been made. An attempt is made here to explain the concept and benefits of free float and give concrete suggestions for its measurement to help turn the idea into reality.
Free float means shares of a listed company that are available to investors for buying. All shares are not available for buying for a number of reasons, such as a large portion may be held by strategic investors who may have to hold on to these shares to control the company.
Having adequate free float and systematically measuring it has three major benefits:
First, free float is required to make market mechanism work. Two fundamental purposes of listing a security—, to provide liquidity and price discovery— can only be fulfilled if there is adequate free float.
There are a number of listed companies at the Karachi Stock Exchange (KSE) which have very little turnover primarily due to minimal free float, causing problems to retail shareholders.
Market pressures on a company to improve its governance are also linked to free float. Those who would want to place a director on the board of a listed company or carry out a hostile take over to change an inefficient management can do so only if they can buy sufficient voting shares from the market.
Second, once free float is measured, it can be used to construct stock indexes that better represent market than those constructed on market capitalization. The free float weighted indexes are superior because, (i) they give weight to constituent companies as per their actual “investability” and are not unduly influenced by tightly held large-cap companies, (ii) they avoid double counting of shares by adjusting for inter-corporate share holdings (iii) they facilitate trading of index futures (iv) they help in establishing mutual funds that track a stock index.
Free float weighted indexes are sorely needed in our market because our bench mark index, KSE-100, which is weighted by market capitalization, is unfit for index futures or index funds. Note that constructing indexes based on free float has already become the international best practice. Some of the best known indexes, such as DJIA, NASDAQ-100, S&P 500, FTSE-100, and those by MSCI are based on free float.
Third, free float measurements can be used for regulatory purposes, such as risk management and market surveillance, by KSE and the Securities & Exchange Commission of Pakistan (SECP).
Using free float, regulators can analyze open interest in stock futures or outstanding positions in regular segment to manage settlement risk. They may consider using free float figures to place limits on open interest. Free float can also help regulators in identifying unusual movements in stock prices and turnover that could merit investigation for potential price manipulation and other forms of market abuse.
As provider of information on stock indexes and front-line regular of listed companies, KSE is best placed to lead the initiative on determining free float. Listed companies should be required to provide KSE their detailed shareholding pattern and the necessary information to determine free float every quarter.
KSE can take three steps to initiate estimation of free float: (a) Form a small group of knowledgeable market participants (investors and listed companies), the Central Depository Company (CDC) and SECP which should be tasked with preparing a detailed methodology for calculating free float, (b) solicit public opinion on report of the group through a consultation paper and, (c) frame regulations that provide legal standing as to how free float would be defined, measured, and used.
To begin with, all shares should be deemed free float unless there is a reason to believe otherwise. That is, we should measure “what is not free float” and treat remaining shares as free float. Shares of a company should be considered “not free float” if there are reasons to believe that these shares are unlikely to be available for purchase till the next quarter. There could be a number of such reasons.
Take these examples: (i) Shares are held for corporate control. This is a reasonable presumption where shareholder is a sponsor, an associated company or the government, (ii) shares are being held in the form of physical certificates.
All physical certificates should be excluded because only shares in book entry form can be settled through the National Clearing & Settlement System; keeping paper certificates implies a desire to hold shares for a very long time and it can take a number of weeks to convert physical certificates into book entry securities, (iii) shares are held by employees of a company as part of a stock option plan or are held by pre-IPO investors. These situations often put restrictions on sale of shares.
All such reasons should be listed out. Then each reason should be turned into a filter to separate shares that are not free float. Starting with total outstanding shares, our first filter could be “exclude physical certificates” leaving us with only book entry securities.
Our next filter could be “exclude government holdings” leaving us with book entry shares in private hands. Following that we could use “exclude shares held by associated companies”, where association is due to shareholding, and so on. What is left after applying all filters should be deemed free float.
Any measurement of free float shall be imprecise and dynamic. In our market, it is not an uncommon practice for majority shareholders to keep their shares in the names of different family members. Isolating these chunks with precision is going to be difficult. Free float would also be a dynamic figure. If some investors sell off their shares, which were considered “not free float”, it would increase free float and vice versa.
Some exercise of judgment would necessarily be required in calculation of free float. It would be best that after initial consultation, KSE sets up a panel of experts that should meet every quarter to determine free float. Over time, free float measurements are likely to become economically sensitive for reasons like introduction of mutual funds tracking a free float weighted stock index and trading of futures contracts on such an index. Therefore, transparency should be built into the calculation process from the very beginning.
Based on information on shareholding patterns given in annual reports, we have estimated maximum free float in our market for top 30 companies. Since we had limited information available to us, we used a simpler methodology, defining maximum free float as total outstanding shares less those held by government, associated companies, and directors. If shares in book entry form were less than that, we took the figure for book entry securities. Our estimate is that free float for these companies is 21 per cent of their market capitalization and 18 per cent of their outstanding shares. Thus if currently the stock market stands at about $32 billion, its float adjusted capitalization is approximately $6.7 billion. If other possible filters were applied, a better estimate could be reached, which might be slightly different from the one given here.
Given the limited free float market and its negative implications, there is a need for a candid debate on whether or not there should be a regulatory minimum free float for a listed company and if yes, what should be that minimum level. There is unlikely to be a standard answer for all companies because what is adequate would depend on a number of things such as company size and how its board of directors is elected. However, need for this debate should not be denied and we suggest that SECP initiate it through the Institute of Corporate Governance.
Time is right to measure free float and realize its benefits. We have enough international precedents and intellectual capacity to meet this objective. Free float is being calculated and successfully used in many countries, including neighbouring India, and we hope that KSE and SECP shall soon take this initiative for the development of our capital market.
