Is Investing In SME Stocks Worth The Risk?

Bhavya Rathod reveals that while the SME markets might not be suitable for the faint of heart, they undoubtedly offer a thrilling landscape for investors who are willing to embrace risk, exercise due diligence, and leverage their understanding to uncover hidden gems amidst the turbulence 

Embarking on a journey that unfolded some years ago, the Government of India laid the foundation for an initiative with the potential to reshape the investment landscape. This initiative, strategically crafted, held a significant purpose: to extend a helping hand to the unsung champions of the business world – the small and medium enterprises (SMEs). This dynamic endeavour aimed to democratize the realm of stock exchange listings, offering these emerging enterprises an opportunity to access investment capital from individual investors. In stark contrast to their larger counterparts with their financial prowess, SMEs often grapple with the uphill task of emerging from the shadows of obscurity. [EasyDNNnews:PaidContentStart]

Thus, when the government gave its nod of approval to this visionary initiative, it sent ripples of enthusiasm coursing through the market – an enthusiastic wave that has continued to shape the investment landscape. With official support in place, the exchanges sprung into action, culminating in the establishment of a specialised platform dedicated to SMEs. This strategic move garnered widespread commendation across the financial spectrum. Investors welcomed the prospect of holding a stake in the burgeoning SME sector, while the proponents of these modest businesses revelled in the assurance that funding would pose less of a hurdle. 

This constitutes a substantial contribution to a nation where SMEs hold pivotal significance, yet grapple with challenges when seeking funds for their growth aspirations. It stands as a potent mechanism for enhancing financial inclusivity. This initiative emerges as a remarkable stride to support the beleaguered SME sector within the nation. The underlying aspiration was that by facilitating access to capital, these modest enterprises could expand their operations and contribute significantly to the Indian economy. Thus, it was only logical for the government to foster such an undertaking.

SME Initial Public Offerings

In the face of challenges encountered by the Indian stock markets within the global context, a multitude of small enterprises that have made their debut in 2023 have showcased impressive performance. Notably, specific companies have achieved remarkable growth, observing their shares appreciate by more than twofold. Several SME initial public offerings (IPOs) have garnered notable oversubscription due to their listing at a significant premium over the issue price. Despite the inherent challenges linked to this sector, encompassing factors like limited disclosure and concessions extended to the issuing firms, investors displaying a pronounced appetite for risk have enthusiastically participated. 

A substantial portion of these investors constitutes high-networth individuals (HNIs), many of whom have previously reaped substantial profits from similar IPOs. Since the previous Independence Day on August 15, 2022, a total of 38 IPOs have graced the main board. The primary markets have experienced a notable surge in funds raised through both private ventures and public sector undertakings (PSUs), fuelled by the vibrant performance of the secondary market. This trend is projected to persist. Throughout the year, a substantial influx of wealth has materialised due to strategic investments across various sectors. Themes like rail, infrastructure, defence, drone manufacturing and export-oriented enterprises have captured the majority of investors’ attention, resulting in noteworthy wealth generation. 

The IPO arena for small and medium-sized enterprises has also demonstrated remarkable resilience. Since the preceding Independence Day, more than 135 SME IPOs have made their debut, contributing to an approximate doubling of the capital mobilised compared to the previous year. In a broader context, the momentum witnessed since April has been notably robust, and what’s particularly encouraging is the significant oversubscription of a majority of IPOs. This underscores the substantial influx of funds into the primary market. Moreover, the upcoming months show a promising line-up of offerings. 

The IPO landscape in India has undergone an impressive transformation, characterised by an unprecedented influx of companies making their foray into the public domain. This phenomenon serves as a definitive testament to the mounting investor confidence in the Indian economy and the thriving start-up ecosystem. Beyond that, these IPOs have played an instrumental role in securing vital capital for these enterprises, facilitating their growth trajectory and operational expansion. 

In 2022, there were approximately 109 SME firms that underwent the process of going public, collectively amassing approximately ₹ 1,875 crore through IPOs. In contrast, the preceding year of 2021 witnessed the listing of 59 SME firms, collectively raising a sum of ₹ 746 crore. However, it’s also important to know that approximately 26 IPOs in 2022 resulted in wealth erosion. Notable among these were Pace E-Commerce Ventures (70 per cent), Ishan International (66 per cent), Global Longlife Hospital (58 per cent), Silver Pearl Hospitality (58 per cent) and Naturo Indiabull (53 per cent) ranking among the most significant disappointments.

Pros of Investing in SMEs

There are various factors in favour of investing in SMEs, such as: 

1) High Growth Potential - In the realm of investing, the allure of high growth potential is a driving force that propels both seasoned investors and newcomers alike. This potential for rapid expansion and robust returns is particularly evident in the context of SMEs in India. The inherent characteristics of SMEs, combined with the dynamic nature of today’s business landscape, create a compelling case for investors to consider SME stocks as a means of tapping into high growth opportunities. An essential component of the high growth potential in SME investments lies in the scalability of these enterprises. When a promising SME hits an inflection point and successfully scales up its operations, the returns on investment can be substantial. 

Early investors who recognise the signs of growth and partner with these SMEs stand to benefit significantly from their expansion journey. As revenue streams increase, market share expands and operational efficiency improves, the valuation of the SME can experience exponential growth, potentially leading to substantial returns for those who got in at the right time. SMEs are ideally positioned to identify and seize emerging opportunities that might go unnoticed by larger, more bureaucratic entities. Whether it’s leveraging technological advancements, addressing unmet needs in niche markets, or pioneering innovative solutions, SMEs can act as nimble trailblazers. This ability to spot and capitalise on emerging trends can translate into a competitive advantage, driving growth that outpaces broader market averages. 

2) Undervalued Gems - The search for undervalued assets has long been a quest pursued by shrewd investors seeking hidden opportunities. This pursuit is particularly fascinating when applied to the realm of SMEs in India. The relatively modest size and limited visibility of these enterprises create an environment where astute investors can uncover hidden treasures – stocks that are potentially undervalued by the market. This situation not only presents a chance to acquire stocks at favourable prices but also offers the prospect of reaping substantial rewards as the broader market comes to recognise their true worth. 

One of the inherent characteristics of SMEs is that they often operate beneath the radar of the larger investment community. Their relatively small market capitalisation and reduced media coverage can result in a lack of attention from institutional investors and analysts. This obscurity can mask the true potential of these enterprises, causing their stocks to trade at prices that do not accurately reflect their intrinsic value. 

For investors with a keen eye, this discrepancy between perceived and actual value creates an opportunity to capitalise on these undervalued gems. Investors who possess the ability to delve deeper, conduct thorough research and recognise the unique strengths of SMEs can find themselves at a distinct advantage. These enterprises might possess compelling growth prospects, innovative products or services, or a strong foothold in niche markets that the market has yet to fully appreciate. By identifying these overlooked factors, astute investors can position themselves to enter the market before the broader investor community catches on. 

3) Diversification - Diversification emerges as a cornerstone strategy to navigate the complexities of financial markets. Within this strategy lies the potential to not only optimise returns but also to mitigate risks. The inclusion of SME stocks in your investment portfolio presents a multifaceted avenue to amplify the power of diversification. SMEs, often characterised by their distinctive operational focus, geographical presence and sectoral niche, can bring a refreshing layer of risk distribution, thereby enhancing your investment armour against market uncertainties. 

At the heart of the diversification strategy is the notion that not all investments react in the same manner to market fluctuations. SME stocks, owing to their unique market dynamics, frequently march to a distinct beat compared to their larger counterparts. Their responsiveness to changing economic conditions, consumer preferences and industry trends can exhibit nuances that deviate from the broader market trends. By integrating SME stocks into your portfolio, you introduce a risk-mitigating element that reacts independently of more mainstream investments, which can prove invaluable during periods of heightened volatility. 

A distinguishing feature of SMEs is their tendency to carve their identity within specific industry segments that might not be the primary playground of larger corporations. This sectoral divergence is where the real magic of diversification unfolds. By incorporating SME stocks operating in industries separate from those dominated by larger corporations, you initiate a powerful mechanism that disperses risk across a broader spectrum of economic sectors. This dispersion significantly minimises the impact of sector-specific downturns on your overall portfolio, effectively shielding you from the adverse consequences of concentrated exposure.

Risks of Investing in SMEs

On the flip side, investing in SMEs also attracts some risks, such as: 

1) Higher Risk - Risk serves as a crucial compass, guiding investors through the treacherous terrain of financial markets. When it comes to SMEs, the risk landscape takes on a distinct character that warrants careful consideration. These enterprises, while brimming with potential, often carry a higher level of risk compared to their larger counterparts. The culmination of their limited resources, susceptibility to market gyrations and potential capital constraints during economic downturns crafts a narrative of heightened risk that demands a thorough understanding for investors venturing into this dynamic arena. 

A fundamental characteristic of SMEs is their comparatively limited resources. These enterprises typically operate with constrained budgets, smaller workforces and narrower operational bandwidths. While this lean approach can foster agility and innovation, it also exposes them to a higher degree of vulnerability. The limited financial cushion translates into a reduced ability to weather unexpected setbacks, market shocks, or operational challenges. This resource conundrum heightens the sensitivity of SMEs to adverse market conditions, rendering them more susceptible to the pitfalls of volatility. 

2) Lack of Information - Information serves as the cornerstone upon which strategies are built and risks are assessed. When it comes to SMEs, however, the landscape takes a unique turn with a scarcity of information posing a significant challenge for investors. These enterprises, while teeming with potential, often operate in the shadows of limited financial reporting and information transparency. This opacity complicates the task of assessing their financial health and growth prospects, necessitating a nuanced approach that blends keen insight with a willingness to explore the unknown. 

Unlike their larger counterparts, SMEs often lack the resources and incentives to produce extensive financial reports that meet the rigorous standards of their more established peers. This limited disclosure can create a veil that obscures crucial details about their operations, revenue streams, cost structures and long-term strategies. The lack of comprehensive financial reporting hampers investors’ ability to make well-informed decisions, leaving them grappling with incomplete puzzle pieces in their pursuit of a holistic view. 

While the challenge of limited information in SME investments is undeniable, it’s not insurmountable. Successful navigation requires a meticulous approach that combines several elements. First and foremost, investors must embrace the role of detectives, seeking out any available information from reliable sources. Engaging with industry experts, conducting site visits and interacting with the management can offer valuable insights that financial reports may not convey. Moreover, investors must recognise that SMEs might have a unique story to tell, one that diverges from the well-worn paths of larger corporations. 

3) Market Volatility - SME stocks often find themselves on the more dynamic end of the market’s pendulum. Their smaller market capitalisation, relatively limited trading volumes and narrower investor base create an environment where price movements can be more pronounced. As market sentiment shifts, economic indicators evolve or sectoral news reverberates,SME stocks tend to react more sensitively, resulting in larger and swifter price swings compared to their larger counterparts. This phenomenon is akin to the energetic arc of a pendulum, swinging through both the heights of optimism and the depths of pessimism. 

While market volatility presents opportunities for gains, it also wields a double-edged sword that demands careful consideration. On one hand, the higher price fluctuations can lead to accelerated portfolio growth during bullish periods. For those who time their entries and exits skilfully, these price swings can translate into substantial short-term returns. On the other hand, the same volatility can expose investments to elevated risk, leading to sudden and significant losses during downturns. The rapid changes in market sentiment can trigger a domino effect of price movements, challenging investors’ ability to stay composed in the face of uncertainty. 

4) Liquidity Concerns - The heartbeat of a liquid market is the steady rhythm of trading activity. For SME stocks, this rhythm often beats fainter. Limited market participation, coupled with narrower investor interest, leads to low trading volumes. This situation can be attributed to factors such as the relatively smaller pool of investors focused on SMEs and the perceived risk associated with investing in these enterprises. As a result, buying and selling actions in SME stocks can have a more pronounced impact on their price levels compared to larger, more liquid stocks. 

The low trading volumes in SME stocks contribute to an environment of heightened price sensitivity. Even a relatively small transaction can exert an outsized influence on the stock’s price due to the limited number of shares available in the market. This sensitivity is a double-edged sword: while it can offer opportunities for savvy investors to take advantage of mispricing, it also magnifies the potential impact of sudden market moves, increasing the likelihood of price disruptions. 

Investors seeking to execute sizeable transactions in SME stocks must tread carefully. The lack of liquidity means that buying or selling a substantial quantity of shares can trigger significant price fluctuations. This creates a conundrum for investors looking to make portfolio adjustments or enter or exit positions. Large buy orders can drive prices higher, and sizeable sell orders can result in price declines. This scenario can lead to suboptimal execution prices and hinder the ability to adjust portfolios efficiently.

Conclusion

The enthusiasm reverberating throughout the SME sector is truly electrifying, ascending to astonishing altitudes. Take, for instance, the story of Srivari Spices and Foods, a firm specialising in the packaging and marketing of spices and flour across Telangana and Andhra Pradesh. This company seized substantial investor interest, drawing a subscription demand that was an astounding 450 times larger than the scope of its SME IPO. With aspirations to procure ₹ 9 crore from the market, the company’s core objective revolved around fortifying its working capital reservoirs. 

Moreover, as of August 31, 2023, the combined market capitalisation (m-cap) of the companies listed on the BSE SME platform has experienced a substantial surge, surpassing the significant milestone of more than ₹ 85,000 crore. This remarkable upswing has been fuelled by robust demand for shares within this segment. With a roster comprising 452 listed companies, the average market capitalisation for these enterprises on the platform stands at ₹ 188 crore. Notably, out of these, a total of more than 170 companies have successfully graduated to the main board. Collectively, these entities command a cumulative market capitalisation of ₹ 27,000 crore. 

While the prospect of significant short-term returns is alluring, it’s imperative to exercise caution and underscore that the sentiment surrounding these offerings can swiftly shift. Even a handful of underwhelming listings possess the potential to erode investor confidence. Considering the nascent stages of many of these enterprises, venturing into investment territory entails a substantial degree of risk. However, it equally opens a door to the potential for substantial profits. Gauging the prospects of these businesses, assessing the calibre of their promoters, and navigating the landscape of corporate governance can be intricate due to the limited operational footprint of these firms. 

This underscores the vital importance of conducting a comprehensive evaluation of these elements, as overlooking this step could lead to considerable setbacks in the long term. Investors should also bear in mind that the minimum investment threshold for SME IPOs stands significantly higher, at around ₹ 1 lakh, as opposed to the typical ₹ 15,000 range for conventional IPOs. Moreover, it’s critical for investors to recognise that although SME IPOs might experience robust liquidity and substantial trading volumes at the outset, such momentum tends to taper off over time. 

Just as with any investment endeavour, a rational time horizon is essential for generating returns, and SMEs are no exception to this principle. Moreover, in the context of SMEs, an investor’s perspective needs to be oriented toward the long term, primarily due to the potential for these companies to transition to the main board of the exchange. Given the liquidity constraints often experienced on the SME platform, investing can be challenging for those seeking a swift exit. In conclusion, while SME markets might not be suitable for the faint of heart, they undoubtedly offer a thrilling landscape for investors who are willing to embrace risk, exercise due diligence, and leverage their understanding to uncover hidden gems amidst the turbulence.

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