The froth in small stocks, and why regulators are worried

 HITESHVYAS & GEORGE MATHEW 

 MUMBAI, MARCH 13

STOCKS OF small companies are showingsigns of becoming bubbles, and regulators have sounded a warning. Over the last five trading sessions, the Smallcap index has fallen by 10% and the Midcap index by 5.9%. In comparison, the benchmark Sensex at BSE has lostonly 1.2%. The Securities and Exchange Board of India (SEBI) has said there is evidence of price manipulation in the initial public offerings (IPOs) and trading in the shares of small and medium enterprises (SMEs). And the apex body of mutual funds (MFs), the Association of Mutual Funds of India (AMFI), last month asked fund managers to act proactively to protect the interests of investors.

Is there a bubble building in small caps and SME stocks? 

Some categories of stocks do appear to be moving ahead of their fundamentals. In the one-year period between March 1, 2023 and February 29,2024, while the benchmark Sensex rose 22%, the BSE Midcap and Small cap indices rose nearly three times that by63%and 65%respectively. Over the same period, the BSE SME IPO index shot up 141%. While the SME IPO index rally is alarming, and the jump in the small and mid cap indices is of concern as well especially when compared with the Sensex, which comprises blue-chip companies. A shar prally in stocks, if not backed by corresponding growth in earnings, makes it overvalued and any correction in the market leads to a sharper decline in those stocks. Thus, while the Sensex has been relatively stable over the last five trading sessions, the Small cap and Midcap indices have fallen much more. 

Are SME stocks being manipulated on the exchanges? 

There are some signs, but the regulator is notable to take action immediately, SEBI chairperson Madhabi Puri Buch said on Monday.

“In terms of actual price manipulation (in the SME segment) both at the IPO level and the trading level, we are working to evidence that, and we do see the signs. ..We are able to see certain patterns. However, as per the regulations, the way we need to construct the entire case, we do need to take some time to do that in a robust manner ,”she said at an AMF levent. Buch said SEBI has received feedback from the market on price manipulation in the listing of SMEs. Market participants have also advised the regulator on ways to identify such cases and to deal with them. While the picture is not clear yet, market sources indicate rigging in the IPO process, and manipulation in prices after listing. “The reality is that these (SMEs) are relatively small entities, the market is small, the free float is small, it is relatively easy to manipulate both at the IPO level and the trading level,” Buch said.

Has there been a lot of market activity in the SME sector recently? 

SMEs have been flocking to the exchanges to list their shares. In 2023, there were 182 SME IPOs, which cumulatively raised more than Rs 4,600 crore, an increase of 150% over the Rs 1,800 crore raised through SME IPOs in 2022. In 2024, the first two months alone saw 30 SME IPOs that collectively raised more than Rs 1,000 crore. The small and mid cap segments have seen a surge in inflows from investors, which has raised the prices of these stocks 100-200% higher over last year. Small and mid caps are companies with a market capitalisation of less than Rs 5,000 crore, and more than Rs 5,000 crore but less than Rs 20,000 crore respectively. Over the past six months, the Nifty Small cap 100index has surged by 33%,and the Nifty Midcap 100 has risen by more than 24%. This is muchhigherthan the 14% growth seen inthe benchmark Nifty 50in the same period. Between August 2023 and January 2024, small cap funds saw net inflows of Rs 22,252.14 crore, and mid cap funds received Rs 13,042.1 crore, according to AMFI data. Over the same period, large cap funds saw net inflows of only Rs 1,577.04 crore. These huge inflows contributed to the surge in small cap and mid cap stocks, with retail investors also jumping on to the bandwagon.

Why is all of this a concern?

Analysts have expressed concorporate high valuations of small and mid cap companies, which pose risks for investors who tend to follow the herd and invest in high-priced stocks without adequate research. Regulators are worried that when a correction comes, investors who invested at high valuations are bound to lose heavily and want the money flow to small cap stocks to be moderated. On February 27, AMFI wrote to its members: “In the context of froth building up in the small land mid cap segments of the market and the continuing flows in the small and mid cap schemes of mutual funds, trustees, in consultation with the Unitholder Protection Committee of the AMCs, shall ensure that a policy is put in place to protect the interest of all investors.” Buch said SEBI could not allow bubbles to build up. “Some people call it a bubble, some may call it froth. It may not be appropriate to allow that bubble to keep building because if it keeps building, then when it bursts... By definition bubbles burst, and when they burst, they impact investors adversely, which is not a good thing,” she said.