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Both BSE Ltd and National Stock Exchange of India Ltd have launched their versions of a small and medium enterprise (SME) exchange this year. The BSE SME Exchange took off with the listing of BCB Finance Ltd in March and the NSE equivalent, Emerge, took off with the listing of Thejo Engineering Ltd last month.

SMEs are small-sized companies often at the beginning of their growth cycle. Small and medium company stocks are known to be at the extreme end of the risk-return curve—very high levels of risk accompany very high levels of return. The entire money can get wiped out, too, in a small company stock due to the very high rate of failure of such ventures. Will the setting up of SME exchange platforms make it any easier for investors to access and invest in such companies?

Need for SME exchanges

When an organization is starting out, either promoters use their own funds or get the help of financial investors such as private equity funds and venture capitalists.

Of course, there is an option of adding debt, which also helps improve the overall return on equity, but the cost of raising debt for SMEs is relatively higher. High interest expense does not look very good on the profit and loss statement of a growing company. Thus, in order to fund the next stage of growth without excessive interest cost burden, companies look to access equity funds via capital markets. This is where listing on an exchange comes into the picture.

While an SME can also list on a main exchange, there are two distinct advantages of using a dedicated SME exchange. First, listing norms are written to specifically suit SMEs. Second, the initial public offer (IPO) process for SMEs is simplified and this means that time taken to prepare for an IPO is much less than for listing on a main exchange. Third, it helps the SME get attention in the stock market. For an interested investor it’s easy to identify, rather than sifting through at least 2,500 small- and medium-cap stocks on a main exchange.

Says Ravi Tyagi, head–SME, NSE, “For the SME, it’s an opportunity to raise funds through sophisticated investors. Listing here means that they don’t get lost in the plethora of stocks in the main exchange." Agrees Devang Mehta, vice-president (equity advisory and sales), Anand Rathi Financial Services Ltd, “Listing is perceived as a prestigious step for a company and it can help them raise more capital in the future." Along with increased visibility and reputation, it also helps in better price discovery and fair valuation opportunity.

Not a first, but with a difference

This is not the first attempt at clearly distinguishing SMEs. The OTC Exchange of India (OTCEI) set up in the early 1990s was probably the first exchange specifically designed for SMEs to list. However, trading volumes didn’t pick up much as compared with NSE and BSE and ultimately for an SME stock to get recognized, liquidity or trading volume has to pick up.

While the recently launched SME exchanges give investors a similar opportunity to identify and invest in such stocks, there is a difference. These exchanges are well-integrated with already established main exchanges, BSE and NSE, hence, the effort required to attract investors for building up trading and liquidity will be easier. The broker, sub-broker network of the main exchanges is nationwide and the SME exchanges can benefit from that.

Getting enough liquidity

The OTCEI experience has demonstrated that the pick-up in trading activity or liquidity is really the key factor for the success of these exchanges. As of now, the stocks listed on BSE SME exchange have very low liquidity starting from around a couple of thousand shares, and not all seven stocks listed get traded every day. It is early days and one has to watch out for how liquidity picks up.

Manish Bhatt, vice-president and head (IPO and primary markets), Prabhudas Lilladher Pvt. Ltd, says, “Currently, SME market investors are looking at some kind of trigger, where they can see proper liquidity on the platform, so once liquidity picks up in a couple of issues, it would trigger trading pick-up on both the SME platforms." If it doesn’t pick up then even for a long-term investor, it may get painful to exit a stock at their desired price.

To overcome this challenge, at least initially, there are market-making provisions. Market making is a way of adding to the liquidity of individual stocks. Market makers are member brokers of stock exchanges registered specifically and they adhere to certain given criteria. Their job essentially is to support the stock by giving two-way quotes on a daily basis and also hold a minimum specified amount of capital or stock in the SME. As Bhatt explains, market makers have to use proprietary funds only for this purpose. And if required by market makers, any designated nominee investors can land money and stock.

How investors benefit

As mentioned, you now have a segregated basket of stocks, which makes it simpler to identify risks and opportunities. Not all SMEs will grow at the same pace; so identifying a winner is a risk. While private equity and venture capital funds have the experience and resources to do the analysis, individually you may not be able to evaluate very carefully each company’s financial health and management capability. According to a BSE spokesperson, “The SME platform is targeted to informed investors as the minimum lot size is 1 lakh."

Even though you can get research reports from the exchanges, given the constraints of in-depth analysis and liquidity, as of now this is more a platform for high net worth individuals (HNIs) and institutional investors. According to Tyagi, “Investors need to understand SME business fundamentals and corporate governance practices before investing and we are helping them understand the companies. At the same time, we are handholding the SMEs in the stage before listing and post listing."

Once trading picks up and market liquidity is enough, then perhaps it would be better for retail investors to consider these stocks actively.

Track the index if you are interested, but resist jumping in for now. If you want small-cap stock exposure in your portfolio, choose from the recommended list of small-cap funds in Mint50, a basket of funds chosen and curated by Mint.

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