Is SME froth building in the Indian IPO market?

This article is authored by Trivesh D, Tradejini

Small and medium enterprises (SMEs) are increasingly choosing to go public as a pathway to grow into larger enterprises. From April 1, 2024, to June 30, 2024, revealed that out of the 45 IPOs launched in India, 30 were SME IPOs, constituting 66.67 per cent of the total IPOs during this period. Specifically, in June alone, 27 IPOs were launched, with SMEs accounting for 20 of them, amounting to 74 per cent of the total IPOs for that month.

This statistic underscores the significant presence of SME IPOs in recent market activity, highlighting their growing popularity among companies seeking public listing. This trend is sparking interest among high net-worth investors (HNIs), driven by bullish market sentiment and an optimistic economic outlook.

In the past

Historically, SMEs have undergone significant transformations post-listing. Initially, promoter’s visions were often short-term, but over time, they adopted a more corporate approach. The success of listing brought about a profound shift in former employees, and second generations, who then became completely involved in it. The period marked a comprehensive evolution in their operations and outlook.

Is it all good?

Investing in SME stocks can be lucrative, but it's essential to be cautious due to the associated risks. SME stocks can indeed offer remarkable returns, but the rapid price increases often lack solid fundamental support. For instance, Varanium Cloud's share price skyrocketed from Rs 40 to Rs 373 before settling at Rs 15. Similarly, Rachana Infrastructure's stock surged from Rs 184 to Rs 1,250 and then dropped to Rs 84. Such extreme volatility exposes investors to significant risks, particularly those who enter the market during peak prices, hoping for continued growth.

Analysis of SME IPOs in the first half of 2024 showed that 43 out of 110 issues doubled investor wealth, with returns up to 1,500 per cent. These high returns, while attractive, also indicate potential market froth. The BSE SME IPO index's 268 per cent rally in one year further underscores the overheated nature of this segment.

Regulators like the Securities and Exchange Board of India (SEBI) have raised concerns about price manipulation in the SME space. Recent actions against companies misusing funds from public offers highlight the need for stricter regulations and investor due diligence.

Indicators of a potential bubble

Pump and dump schemes

A common risk in the SME segment is the pump-and-dump scheme, where stock prices are artificially inflated by misleading information. Once prices peak, the perpetrators sell off their holdings, leaving unsuspecting investors with depreciating stocks. This reversal after the peak can cause substantial losses for retail investors who bought into the hype.

multibagger returns

Several SME IPOs have witnessed astronomical returns on listing day itself. For example, a recent SME with a premium of 211 per cent was listed on its first day. While these gains attract investors, the lack of corresponding fundamental strength makes these stocks highly speculative.

Questionable fundamentals

The rapid appreciation in SME stock prices often lacks underlying fundamental support. Many of these companies do not have consistent profit growth or robust business models to justify their high valuations. High price-to-earnings (PE) ratios without matching profit performance are red flags. Investors should be wary of stocks that command high PE ratios without demonstrating consistent profit growth, as they are likely overvalued and vulnerable to sharp corrections.

Collusion and manipulation

There have been instances where promoters and operators, including high-net-worth individuals (HNIs), collude to manipulate stock prices. A notable case is ‘Add-Shop E-Retail,’ where fraudulent sales were conducted between two companies to inflate stock prices. Such collusion undermines market integrity and can result in significant losses for retail investors who fall prey to these manipulative tactics.

Pre-IPO allotments

Pre-IPO allotments to operator entities can skew the market dynamics of SME stocks. These entities may control significant shares and manipulate prices post-listing to create an artificial demand-supply imbalance. Retail investors who fall for the hype peddled by these operators may find prices abruptly correct, putting them at a disadvantage once the manipulation stops.

Investor beware

Despite efforts by stock exchanges to regulate SME IPOs, such as the NSE's 90 per cent price control cap, speculation remains rampant. Investors must always analyse the company’s financials, profitability, growth potential, and operational transparency. High P/E ratios without corresponding profit growth should raise red flags.

The question

While SME stocks offer high returns, the risks from speculative activities, price manipulation, and weak fundamentals must not be overlooked. Investors should conduct thorough research and avoid getting swayed by promises of quick profits. Thus, the question remains: Is the froth in the SME segment building?

Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ