Is Small Bountiful?

The SME exchanges of the BSE and the NSE offer investors a route to buy into under-researched stocks that can become multibaggers. But look before you leap

For stock market players on the lookout for investing ideas that can generate outsized returns over the next few years, SME (Small and Medium Enterprises) stocks present an opportunity. This sector, along with the broader MSME sector (that additionally takes in micro enterprises), plays a somewhat under-appreciated role in powering the economy. If India is to remain the world’s fastest-growing economy and generate jobs in sufficient numbers, the MSME sector needs to fire on all cylinders (see box: Government lends a hand) and the Centre needs to come up with a long-term plan for enterprises in this segment.

Given these companies’ relatively smaller sizes, they have the capacity to grow their earnings faster than their larger peers; that could drive up their stock prices. On the flipside, these companies take a harder knock during slowdowns. A report of the RBI expert committee on MSMEs noted that when the economy expands, MSMEs grow faster – as happened between FY01 and FY07 and again from FY14 to FY16. But when the economy slows down, the contraction in MSMEs’ growth rate is more pronounced, as happened between FY10 and FY13.

Since these companies have the potential to grow faster when the economy gets going, it could pay to add a few of these stocks to your portfolio. One way to buy into tiny companies is through the SME exchanges of the BSE and the NSE. These exchanges are fairly new, having been launched in 2012. But both have seen brisk action: some 185 companies with a cumulative market cap of around ₹11,000 crore are traded actively on the NSE SME platform; likewise, about 237 companies with a total market cap of around ₹11,500 crore trade actively on the BSE platform.

Many of these stocks have delivered multi-fold returns to investors; some of them have even migrated to the main board, thus offering higher liquidity. HSBC, DSP and Reliance mutual funds have invested in them, and ace investors such as Madhusudhan Kela, Mukul Agarwal, Ramesh Damani and Nikhil Vohra have picked up some of these stocks from SME exchanges.

Investors, however, need to exercise abundant caution while investing in these companies. Limited disclosures and the paucity of coverage by analysts and the media makes information about them rather scarce. Their smaller business size and the lower entry barriers make them more vulnerable. Also, the poor liquidity is an impediment for larger investors and for trading.

The terms of listing

The SME platforms of the BSE and the NSE were launched to enable smaller companies to raise capital without having to go through a formal IPO (initial public offer) or meet stringent post-listing disclosure requirements.

Companies with a three-year track record can get on the SME exchanges if their post-listing share capital is less than ₹25 crore, and if they have positive networth, net tangible assets of at least ₹3 crore and positive cash accruals from operations.

The BSE SME exchange allows those with a track record less than three years to list if they have obtained loan or equity from banks, financial institutions or the government.

It is mandatory for SME companies to have a website, and to provide facilities for dematting securities; there should not have been any change in the promoters in the year leading up to filing the application. The company also needs to certify that it faces no insolvency or winding-up proceedings.

How they differ

So how is the listing and trading process different between the Main Board and the SME exchange? To make fund-raising easier for SMEs, the IPO process has been simplified. The SMEs’ IPO documents are not vetted by the stock market regulator SEBI, and the exchanges give in-principle approval.

To mitigate risks, the regulator has prescribed an IPO subscription size and a trading lot size of ₹1 lakh. This means that the turnover on SME exchanges is typically low: many stocks are not traded everyday. To address the illiquidity, ‘market-making’ has been made mandatory for SME stocks: the ‘market maker’ has to give two-way quotes, for buying as well as for selling.

Subsquent disclosure norms are not as stringent in the case of SME listed shares. The shareholding pattern and unaudited results have to be disclosed every six months and annual reports have to be disclosed every year. However, there is no requirement to publish the results in newspapers or to circulate annual reports to shareholders. Companies can file with the exchanges and post the information on their websites.

But other governance requirements — in terms of minimum number of women directors, independent directors, audit committees, applicability of takeover code, insider trading rules and so on — apply here as well.

How they score on returns

Many of the stocks listed on the BSE and the NSE SME platforms have, as stated earlier, proved to be multibaggers.

Raghuvansh Agrofarms, which listed on the BSE’s SME platform, is up 1,571 per cent since its listing in January 2015; Eco Friendly Food Processing Park has appreciated 1,005 per cent since listing in 2013; and HPC Biosciences is up six-fold since listing in March 2013. Of the 237 stocks on the BSE SME platform, for which trading data is available, 39 stocks have doubled their value since listing.

The NSE’s SME platform, too, has multibaggers. Madhav Copper is up 1,594 per cent since listing in February 2017; and Mittal Life Style and Shrenik have gained around 700 per cent since their respective listing.

While the success stories sound good, there are also a substantial number of stocks trading below their listing price. Of the 185 stocks actively traded on the NSE SME exchange, 124 are trading at a loss; 49 companies have lost over 50 per cent of their listing price.

On the BSE SME exchange, 122 of 237 SME companies are trading below their listed price; 97 companies are down more than 20 per cent below their listed price.

Fundamental performance

That such a high proportion of companies on the SME exchanges have failed to deliver returns to investors since listing accentuates the need for caution while stock-picking in this pool.

Out of 216 companies on the BSE SME exchange for which results are available for FY19, 121 had profits of less than ₹1 crore; and 29 others recorded losses in FY19. Around 13 companies, or only 5 per cent of the universe, made net profit over ₹10 crore.

On the NSE, of the 184 companies that have filed their FY19 results, 13 were loss-making and 36 had net profit under ₹1 crore. In other words, 19 per cent of the companies were making scanty profits. Only 10 per cent of the companies on the NSE SME platform made profit of over ₹10 crore. But the quality of the companies appears better on the NSE, with 35 per cent of the companies recording a turnover over ₹100 crore.

How to pick SME stocks

So, given all this, how do you avoid picking lemons while picking stocks listed on the SME exchange?

Stick to fundamentals: SEBI has stipulated that annual reports and half-yearly numbers should be filed with exchanges and put up on company websites. Look for some key financial numbers on the company websites. Choose companies that have a track record of profitability and generate healthy operating cash flows.

Look for institutional holding: With some mutual funds and Alternative Investment Funds (AIFs) beginning to nibble at these stocks, you can skim through the shareholding patterns of the companies. Those in which mutual funds have invested are likely to be better governed. For instance, Macpower CNC Machines, One Point One Solutions, SS Infrastructure Development Consultants, South West Pinnacle Exploration and Valiant Organics have mutual funds as investors.

Study the business model: The companies’ smaller sizes renders them more vulnerable to business cycles. However, companies in niche markets will see demand for their products even when economic conditions are adverse. Thejo Engineering and Manorama Industries, discussed below, are cases in point.

Have an eye on migration potential: Companies that are likely to migrate to the main board will typically offer higher returns since liquidity and product demand increases with such migration. The migration comes with a few conditions: companies must have been listed on the SME exchange for at least two years, and their paid-up capital must be above ₹10 crore.

To migrate earlier than two years, the company should have a turnover of ₹100 crore, market capitalisation of ₹100 crore, and a minimum profit before tax of ₹10 crore for two of the three previous years. Also, the company should not face any adverse action by any regulatory agency at the time of application for migration. Filtering stocks based on this criteria may help.

A tableau of SME stocks

If you are wondering what kind of stocks are listed on the NSE SME platform, here is a bird’s eye view of some companies. This is, however, not a recommendation to buy: a bit more due diligence is required before buying these stocks.

Valiant Organics: Valiant Organics, established in 1985, is a major suppliers of chloro phenols, a chemical used as intermediates in pharmaceuticals, pesticides, disinfectants, anti-bacterial and veterinary industry. The stock has gained 544 per cent since its listing in October 2016. The company reported a topline of ₹606 crore and net profit of ₹133 crore in FY 19. It reported robust operating and net profit margin of 32 and 22 per cent respectively in FY19. The company plans to expand its current capacity of total Chloro Phenols production from 4,800 million tonnes per annum. The market capitalisation of Valiant Organics is ₹997 crore, and it currently trades at a price-earnings multiple of 7.4. Reliance Mutual Fund holds 39,150 shares of the company.

Manorama Industries: Manorama Industries, listed on the BSE SME exchange, has a unique business model, which abides by the sustainability theme; it could, therefore, find a place in ESG ETFs in future. The company reported revenues of ₹102.8 crore and net profit of ₹19 crore in FY19. It listed in October 2018 and has gained 5 per cent since then, despite difficult market conditions.

The company began with extracting butter and fats from sal seeds and mango kernel and then moved on to exotic products and specialty fats used in cosmetic, chocolate and confectionary industries, many of which are reported to be Fortune 500 companies. It currently trades at a price-earnings multiple of 11.

Thejo Engineering: Thejo Engineering, the first company to list on the NSE’s SME platform in September 2012, is currently trading at ₹508, which is 182 per cent above its listing price. The company’s market capitalisation has also risen to ₹175 crore.

The company is a leading industrial solution provider for belt conveyor-based bulk material handling systems, mining & mineral processing and corrosion protection application. It reported a turnover of ₹190 crore and net profit of ₹13.57 crore in FY19. The operating and net profit margins were 14.5 and 7.1 per cent, respectively. It is currently trading at a price-earnings multiple of 12.8.

Mittal Lifestyle: Mittal Lifestyle is an example of how stocks on these platform, given their small market-cap, are prone to sharp price spikes. From its listing price of ₹12.6 in April 2018, the stock has gained 717 per cent to ₹102. This has taken the price-earnings multiple to 79.8.

The market cap has also expanded, as a result of the rally, to ₹120.9 crore.

The company, established in 2005, is a distributor and supplier of fashion fabrics, cotton canvas denims, Dupion bottom fabrics, polyester, cotton and knit fabrics to textile industry. It buys the material from manufacturers, creates smaller material units and delivers them to customers.

The topline for FY19 was ₹89.7 crore, and the net profit was ₹1.5 crore.

Government lends a hand

Given that MSME sector contributes 28 per cent to the economic output, 45 per cent to manufacturing output and over 40 per cent to exports, successive governments have provided incentives and removed roadblocks for the companies in this segment. In Budget 2019, too, Finance Minister Nirmala Sitharaman announced interest subvention of 2 per cent on loans taken by all GST-registered MSMEs and proposed a payment platform for MSMEs for filing bills and payments related to the government.

Besides this, the corporate tax rate has been reduced to 25 per cent for companies with a turnover of up to ₹400 crore. This covers all MSMEs since, according to a government proposal, enterprises with a turnover between ₹5 crore and ₹75 crore would be categorised as small enterprises, while businesses with revenue between ₹75 crore and ₹250 crore will qualify as medium enterprises.

Benefits of registration

The Centre provides various benefits to companies that register themselves as MSMEs.

The Credit Guarantee Fund Trust for MSME provides collateral-free loans to micro and small enterprises. A 50 per cent subsidy is provided on patent registrations by MSMEs, and a 1 per cent exemption is available on interest rate on overdrafts in some banks. Industrial promotion subsidy is provided as prescribed by the government from time to time.

On applying to the electricity department, these enterprises can get a concession on their power bill. They can also claim reimbursement of the expenses incurred in obtaining an ISO Certificate.

 

 

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