17,000% return in 10 years but this market segment is a tough play

SME stocks are India’s best-performing market segment, which may give the impression that making money is easy but lack of insight, excessive froth and scarce liquidity mean it is anything but true

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If you were to guess the best-performing index across the BSE and National Stock Exchange (NSE) in the last 10 years without looking at the data, in all likelihood you would be wrong. The answer is the BSE SME IPO index, often overlooked by investors.

The index, launched in 2014 to track the performance of companies landing on the BSE SME platform, has a unique structure. Its constituents are those that debut on the platform. After completing a year, they are excluded from the index, unlike Nifty or Sensex where constituent stocks can be part of the index for years.

This unique structure makes it difficult to track the performance of companies over a longer term. Nonetheless, the stellar performance shows increased demand for small and medium enterprise (SME) stocks among a niche set of investors.

However, this steady rise also highlights the unsustainable valuations and a possible manipulation of prices in some pockets, which is often the reason behind such stocks being punished when they migrate to the mainboard exchange.

Big returns, bigger risks

The BSE SME IPO index has delivered an eye-popping 17,250 percent returns in the last 10 years, rising at a compound annual growth rate of 67.45 percent. This means just Rs 1,000 invested in the index at the beginning of 2013 could have been worth Rs 1.72 lakh today.

In the last five years, the index has compounded at an average 63.59 percent a year and in the last three years, nearly 140 percent every year. What is remarkable is that the rally shows no sign of slowing down.

Most SME companies that debut at the BSE SME platform try to raise a relatively smaller amount of money. Regulator requirements for an SME initial public offer (IPO) is relatively lax, which attracts smaller companies that are in their initial phase of business. As of January 5, about 400 companies have raised Rs 4,543.72 crore.

“There are a lot of companies who are coming up with unique ideas and good businesses,” said Mohit Nigam, head of portfolio management services at Hem Securities. Nigam also manages perhaps the only regulated fund that invests in SME stocks.

Investors have rewarded such initiatives and businesses. Data shows some of the stocks that debuted on SME platforms went on to deliver up to 10,000 percent returns in just a few years.

Despite such colossal returns, making money in the SME segment is not an easy task. Even Nigam, who has a team to do research, admits to this. The effort required and risk assumed for retail investors who want to invest in their own capacity is only higher as there is little research available for these stocks, if any. “It’s very difficult to crack at a retailer level,” said Nigam.

In Nigam’s case, he has a few analysts who track different sectors. He allocates a company to the respective analyst who will go through the IPO prospectus and annual reports of that company. This is followed by the usual fundamental analysis.

“We do as much research as possible and take a call because this is a risky game,” said Nigam, who added that even after making an investment you need to track these companies very rigorously.

Although you can find some good opportunities in the SME space, it comes at a cost. In the final analysis, it all comes down to, as a retail investor, how much time you can devote and how big your risk appetite is. If both are on the lower side, investing in SME stocks is not your cup of tea, suggest analysts.

Nirav Karkera, head of research, Fisdom, a wealthtech platform, agreed that there are a couple of pockets that investors can identify as opportunities. However, considering the thin coverage and limited insights in the public domain, identifying such opportunities may be challenging, he added.

“An investor must also acknowledge that while recent performance is charming, the same is largely irrelevant to performance prospects going ahead,” said Karkera.

Reality check

Another lure that attracts SMEs to the BSE SME platform (or rival NSE Emerge – a similar platform) is the possibility of migration to the mainboard—the segment where big boys like ICICI Bank or Tata Motors are listed—without any lengthy IPO process.

All they have to do is fulfil certain conditions set by the exchanges that include a minimum market capitalisation of Rs 25 crore, shareholders’ approval and directors and promoters not barred by the Securities and Exchange Board of India (SEBI). As of January 5, a total of 410 companies have landed on the BSE SME platform, of which 159 companies have chosen to migrate to the mainboard, according to data provided by Prime Database.

What stands out is the disparity in stock performance before migration and following it. Some of the best performers on the BSE SME platform get a reality check on the mainboard where there is greater scrutiny in terms of disclosure, valuation and management quality.

EKI Energy is the best case study. The company, involved in the carbon credit business—a niche field—saw massive demand and rallied nearly 9,000 percent while it was part of the SME platform but is down 43 percent after migrating to the mainboard. Suyog Telematics, Sunstar Realty and DJ Mediaprint & Logistics are some other names that have fizzled out after migration. Overall, half of the stocks that migrated to the mainboard have delivered negative returns from their respective migration date.

This points towards a froth in the SME segment where valuations have run too high. This is also endemic to inefficient price discovery in many pockets, which fund managers say could also be due to low liquidity.

“There will certainly be some froth in stocks,” said Nigam. “But the market has its own way of rewarding and punishing, sooner or later. Only the companies which have a sound track record, good management, which are able to meet their revenue and growth projections are sustainable. The wheat will separate from the chaff at the end of the day.”

It is worth noting that there are some outliers. Thirty-nine of these names have delivered greater returns on the mainboard than their SME platform days, some of which that did not perform well before migration while others continued their outperformance.

“It is important to evaluate businesses and valuations from a highly objective perspective,” said Karkera. “For such businesses, special emphasis must be laid on the management’s competency and intention along with quality of earnings with as much rigour as quantity is considered.”

Scarce liquidity

Since there is negligible research, most of the retail demand that comes to the SME platform is word-of-mouth publicity or thanks to tips and suggestions from friends or social media.

In a bull market, more investors pile into such stocks where returns are superlative. This, analysts say, leads to more demand and less supply, meaning low liquidity and ever-rising prices.

Nigam said lack of liquidity can also be a big driver of prices in some stocks. Though he denied any knowledge of any stock manipulation in the SME segment, he warned that if the price starts falling and liquidity suddenly dries up in any stock, it can lead to disaster for an investor who is not diversified. This is the risk every SME investor should be aware of.

“Stock-specific details such as liquidity must top the checklist,” Karkera also underlined. “Unlike much larger counterparts where a hybrid approach helps, a bottom-up approach to analysis of companies listed on the SME board should improve the decision quality.”

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.