Even as the bull market raged on in the Indian stock market in 2017, the exchange platforms that exclusively trade stocks of small and medium enterprises (SME) have also witnessed increasing interest. Many stocks on the SME platforms of the BSE and the NSE have vaulted, delivering strong gains. The BSE SME IPO index gained 93 per cent in 2017, outdoing the Sensex’s 26 per cent return. It also managed to outdo the BSE Smallcap Index’ 63 per cent gain in the same period.

But before you rush to your trading terminal to key in orders to buy SME stocks, there are a few things you need to know.

About the platform

The objective behind an exclusive platform for SMEs on stock exchanges was to allow smaller companies to raise capital through the stock market. Since these companies have limited resources, the listing procedure is easier here and compliance rules more lax.

For instance, the minimum number of subscribers in an SME IPO is 50, while IPOs on the main board require at least 1,000 subscribers. The prospectus of SME public offers is vetted by the stock exchange whereas SEBI clears the offers made on the main exchange. The requirement to have track record of at least three years in profitability is also waived in case of SME offers. The post-issue capital should not exceed ₹25 crore in SME IPOs, while the size should be at least ₹10 crore for issues on the main board. Companies have also been allowed to file financial accounts half-yearly with exchanges and not quarterly, as is the case with companies on the main board.

However, lower disclosures and relatively lower scrutiny at the time of initial public offers in SME stocks tend to increase risk. The regulator has tried to ensure that only investors with deeper pockets and higher risk-bearing capacity dabble in SME stocks by imposing minimum subscription limit of ₹1 lakh in SME IPOs. Trading lot size on this platform is also high, around ₹1 lakh thus disallowing trading in smaller quantities.

Retail investors with a small trading capital cannot invest in these stocks, given the high lot size. Also, the higher risk in these stocks means that those with low risk-bearing capacity should stay away from this platform.

Some positives

As the numbers given above indicate, the ability to generate returns is much higher in these micro-cap stocks due to the smaller size. Stocks such as Aditya Consumer Marketing, a Patna-based supermarket operator, and Yash Chemex, a fine and specialty chemical company, have delivered five-fold returns over the last one year. Many others such as Darshan Orna and Sri Krishna Constructions were also multi-baggers in 2017.

It’s not just stock price performance, but business growth in these companies can also be at a faster clip due to the lower base. For instance, almost 30 out of 200 stocks listed on the BSE SME platform recorded sales growth of over 100 per cent in FY17. Half the stocks recorded over 15 per cent growth in sales. Of the stocks listed on the NSE, 40 per cent grew their sales at a rate of more than 15 per cent. Diversity in businesses in the stocks listed on these platforms is another argument in favour of buying these stocks.

But concerns galore

There are, however, many concerns that you should be aware of, before deciding to buy SME stocks. Liquidity is among the major concerns in this segment. Due to the limit in the lot size in trading, limited number of subscribers in IPO and small market capitalisation, volume is very thin on both the BSE and the NSE. Daily traded volume on the NSE and the BSE is less than ₹50 crore.

Also, not all stocks are traded everyday. While around 50 per cent of the stocks are traded daily on the BSE, the proportion is better on the NSE at 70 per cent. But most stocks on both exchanges are traded at least once a month. This means, if you keep keying in your purchase or sale order every day, there are chances of it getting executed in about one month’s time, for most SME stocks.

Lack of liquidity also keeps institutional investors away; HNIs account for a major part of the turnover in this segment. If you want to buy an SME stock, you will do well to zero in on those with relatively higher turnover, so that exit does not become too difficult. You could also try to move to counters with active market makers who can provide additional liquidity.

With most fund houses or foreign investors not willing to look beyond the top 500 stocks in the Indian stock market, information and research in the rest of the stock universe, including the SME stocks, is quite limited.

Investors would therefore need to read through the disclosed financial numbers carefully before selecting the company to invest.

Also, if you thought you could get the stocks listed on SME platforms at cheaper valuation, you are mistaken. Around 35 stocks listed on the BSE SME platform sport three-digit PE multiples. While part of this steep valuation could be due to the business turning around after a loss-making phase, the lack of liquidity also plays a part in driving up valuation of the comparatively healthy stocks.