Why investors must be extra cautious about SME IPOs

At a time when the mainboard IPOs had been reduced to a virtual trickle, the SME IPOs are virtually making hay. The mainboard IPOs may have had problems like start-up funding, aggressive valuations, earnings growth etc. SME IPOs don’t seem to have any of these problems. At least that appears to be the case on the face of it. The recession fears and the concerns of the broader market have not really deterred or even intimidated the scores of small and medium enterprises of India that are entering the primary market this year. Surprisingly, it is not just supply, but even demand for such SME IPOs have been robust.

Just look at the numbers and it almost looks like the year of the SME IPOs. Even amidst all the chaos of FPI selling, rupee weakness, valuation worries and global slowdown apprehensions, the secondary markets saw a total of 87 SMEs IPOs launched in the calendar year 2022 so far. We have just completed 9 months of the year, so by the end of the year we could see IPOs well in excess of 100 SME IPOs. In all, the total collection has been Rs1,460 crore. This appears in the context of mainboard IPOs, but remember that this compares very favourably with Rs783 crore raised via 56 IPOs in calendar year 2021.

If you just look at the current fiscal year starting from April 2022, then a total of SME IPOs have hit the IPO segment for SMEs and collected close to Rs1,078 crore. It is not just the yoy comparison, but even amidst the virtual drying up of mainboard issues, the SME IPO surge is gratifying and also rather surprising.

However, most of the analysts are of the vie that it is a healthy signal and shows that small companies with good business models are getting the money they need and the money they deserve to get. Also, being small in size, the macro liquidity problems have not really impacted the sentiments surrounding the SME IPOs.

There are reasons to be cautious too

One can argue that the share of SMEs in the Indian market cap is less than 1% so this is the much needed revert to normalcy. However, that would be too naïve an argument. Not all of the SME IPOs are going to become the superstars of tomorrow. Remember, most of these SME IPOs have extremely vulnerable business models with their entire turnover dependent on a handful of clients or outsourcing orders. There is very little long term loyalty of clients in this business and clients are more than willing to switch at short notice. So in the absence of such entry barriers, the big question is whether such enthusiasm is really justified?

The small company argument that applies in the normal market would logically apply here also. It is the small caps and mid cap that become large caps. Large caps find it a lot tougher to become super large caps. That is why most of the wealth is created in smaller companies and not in the large frontline stocks. However, that said, one must not ignore the risks that come with this approach of buying SME IPOs just because they are available at apparently reasonable valuations. If you were to ask the biggest single risk for these SME companies, it is their overt dependence on export orders and that is what is now under pressure.

Here is where there is a reason for caution on SME IPOs and it has largely to do with exports. It has been exhibited that over 40% of India’s exports have been directly or indirectly driven by the medium and small enterprises or MSMEs. This is true of most of the sectors. However, the problem now is the ongoing slowdown in global trade. The anticipated recession in the US, UK an Europe is raising the spectre of a slowdown in exports and that is already visible in the recent export numbers. If you look at the latest negative IIP figure for August 2022, the pressure points have come largely from export driven products.

One must not forget that the US and EU contribute 50% of the exports by MSMEs and that is where the slowdown is going to be the harshest. If the global situation worsens and recession is rampant, then it would leave deep scars on the performance of MSMEs. Many of these SME IPOs doubled value in no time and that type of bumper returns can mislead investors. Investors can still put money in SME IPOs, but they must keep the risks at the back of the mind. As they say, in the stock market, there is nothing like a free lunch. Everything comes with a cost and investors must ensure that the cost is not too steep.