Manic microcaps

| Updated on March 09, 2018 Published on

Small-cap stock valuations are turning frothy and the low institution participation makes these stocks vulnerable to manipulation

Apart from shoeshine boys offering stock tips, another sure sign of a frothy equity market is unusual buoyancy in small-cap stocks. On this count, a BusinessLine analysis of the recent market rally found worrisome trends. Eighty per cent of the stocks that shot up by 50 per cent or more in the last one year and 90 per cent of those that trebled, were small-caps (market capitalisation of less than ₹2,000 crore). Many of these stocks now sport triple-digit price-earnings (PE) multiples and the BSE Small-cap Index trades at a 67 PE. This is clear evidence that price gains in many cases had little fundamental backing.

Despite the strides made by Indian regulators in curbing price manipulation in the large and mid-cap segments of the market, small-caps remain vulnerable to rampant price rigging and fraud. In India, both foreign and domestic institutional investors favour large and mid-cap stocks for liquidity reasons. Retail ownership rises sharply as one goes down the market-cap scale. Lack of research into small companies and thin trading volumes also render them easy to manipulate, especially given retail investors’ undying fascination with low-priced ‘multi-baggers’. In recent years, the classic pump-and-dump operation — where promoters team up with operators to bid up a stock through rumours — has become far easier to practice with technological help. Bulk SMSes, WhatsApp groups and social media platforms are widely used to disseminate bogus news on companies, reeling in hundreds of investors in an instant. SEBI has tried to curb this by requiring compulsory registration under its Research Analyst regulations for all entities offering securities recommendations. But given the multitude of platforms from which investors receive such free advice, it hasn’t succeeded at muzzling it. The exchanges attempt to curb such ‘news’ flow, by seeking explanations from listed firms on unusual price action. But dubious companies have perfected the art of nullifying this effort through perfunctory and inane responses.

One solution left may be for the exchanges, as first-line regulators, to up the ante by deploying technology to tighten their real-time surveillance. In mid-March, the bourses did introduce a new set of graded surveillance measures to flag stocks trading out of sync with their fundamentals. Suspect stocks are now subjected to graded trading restrictions, ranging from tighter price bands, to higher margin requirements, to infrequent trading windows and even suspension. BSE is also segregating stocks into buckets such as XC, XD and XT, apart from the conventional Z and T groups, to caution investors. But while such moves help warn off new investors, they also impede liquidity for existing investors. Such preventive measures apart, strong enforcement action by SEBI on manipulation can serve as an effective deterrent. But ultimately though, it is retail investors who need to realise that punting on small-cap stocks is a high-risk game, where the only rule that applies is caveat emptor — buyer beware!

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Published on April 11, 2017
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