SME IPOs: High Rewards Come With High Risks

The Standard & Poor’s BSE SME IPO index has grown multi-fold over the last year. An investment of Rs 1 lakh into the index a year ago would have yielded Rs 8 lakhs today. In contrast, the same investment in the S&P BSE IPO Index would have yielded just Rs 1.71 lakhs.

Over the last five years, the SME IPO index grew almost 11 fold, whereas the mainboard IPO index grew just under three times.

The BSE’s Small and Medium Enterprises fundraising platform has seen immense investor interest over the last few years, with IPOs outperforming most mainboard IPOs. The BSE SME platform, along with the National Stock Exchange’s NSE Emerge, focuses on helping smaller companies raise capital from investors. After raising capital through an IPO, the shares trade on the SME exchange.

Investors can invest in companies that are just beginning out in the corporate world, and hope to ride the wave till the companies grow bigger. For investors who do not have funds to invest into start-ups and similar small companies, the SME Exchange offers opportunities to do so.

For smaller companies, the SME exchange offers an easy way to raise equity and support the business, rather than relying on banks. Several top investors have been buying into some SME.

The excellent performance, however, comes at a price. The segment is quite risky, with several factors that could make it difficult for retail investors to navigate the segment.

Here are some of the factors that should be kept in mind before jumping on to the SME bandwagon, looking at the recent performance of a selected group of SME stocks.

Small Size of Operations

These companies usually have extremely low revenues - usually below a hundred crores. Profitability is patchy, low, or non-existent, as the business is still at a relatively nascent stage. The focus of the business is to invest in expanding the sales network, manufacturing capacity, client base etc. As a consequence, these companies have lower margins and lower profits, as compared to a mature firm with an established base.

Small size of operations would also mean that the company does not enjoy some of the benefits of a scaled business model that a larger business does. The cost of capital is much higher as well, since banks consider loans to these companies to be risky assets.

As a consequence, during tough times, smaller companies might find it difficult to be able to repay high-cost debt. These companies are unlikely to pay dividends since they usually do not have any free cash flows. Hence, investors looking to receive regular dividends might be disappointed.

Short Operating History

Given that these are smaller companies, their operating history is relatively short. And hence, it could potentially be difficult for investors to determine whether these companies could offer high returns over time.

Usually, a longer track record gives a better idea of business performance across business cycles. As a result, a shorter operating history might not convey the potential risks and rewards in entirety.

Commoditised Businesses

Like most mainboard businesses, a majority of the businesses listed on the SME exchanges are businesses that are involved in sectors where producers lack pricing power. While larger companies might be able to withstand longer durations of low-demand periods, smaller companies might find it difficult to survive such over periods. As a result, investors should be careful about investing in small companies with undifferentiated business models.

Undoubtedly, some of these companies could do well over the short term, but over the long term, the chance of outperformance among undifferentiated businesses is low. The mainboard, however, offers several businesses that have differentiated themselves on the basis of brands, scale, technology, research, and other factors.

Low Regulatory Overview

An SME Initial Public Offering is not subject to the stringent rules that mainboard IPOs are subjected to. As a result, these companies get more leeway in terms of reporting and disclosures.

For instance, there are relaxations on filing related party transaction disclosures, financial results, vetting of various documents, and other reports. Therefore, investors used to the high level of disclosures in listed companies might find the lack of disclosures in the SME space disconcerting.

Low Liquidity & High Volatility

The SME markets have low liquidity due to restrictions on lot size and other factors. The large lot size of shares required to make a trade, dissuade small investors from buying into SMEs. In addition, lower liquidity implies high impact costs and high volatility. Even a small volume of shares traded and a small float, can easily ramp up stock prices or pull them down.

In the past, some entities have been accused of price manipulation in SMEs. The IPO shares are sometimes cornered by operators to reduce the float, bump up the stock price, trap unsuspecting (and greedy) retail investors, and finally exit the stock. Often promoters are hand-in-glove with such promoters.

Quite clearly, SME investing might not be suitable for everyone. Investors should decide to invest in SMEs only if they understand the risks, have a right time-frame, and understand the business. In addition, as highlighted above, SME IPOs have been manipulated in the past. Hence, careful consideration of these factors should help investors make better decisions when investing in SMEs.

Also Read: Forget Zomato: BSE’s SME IPO Index Has Quintupled In Seven Months