What drives SME IPO mania? 6 key points retail investors should know before applying for an issue

There is a deluge of initial public offerings (IPOs) in India. Over 55 mainboard IPOs have hit the Indian market this year so far. However, the real buzz is in the small and medium-sized enterprises (SME) segment, with over 150 SME IPOs in the year.

An influx of IPOs is a positive sign as it indicates upbeat market sentiment and healthy economic growth. SMEs contribute significantly to economic growth and employment generation, and it is desirable that more companies go public.

However, what is not desirable is the intense obsession of retail investors for the IPOs of companies without sound fundamentals.

Several SME IPOs have seen perplexing oversubscription, leaving experts scratching their heads about what is luring retail investors to them.

“SMEs contribute substantially to India’s GDP and employment generation. It is a positive and desirable development that they are getting access to the capital market. It has to be encouraged. But, recent developments indicate excesses. IPOs of SMEs without any track record and sound financials are often getting oversubscribed, driven by retail investors chasing listing gains. These are excesses that need to be checked. Experience tells us that speculative excesses lead to tears,” V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, pointed out.

What is driving SME IPO mania?

The pursuit of listing gains and expectations of robust long-term returns lure retail investors to IPOs. While the objective is logical, betting on new issues without understanding the company’s fundamentals, valuations, and potential risks proves fatal.

Experts believe abundant liquidity, the fear of missing out (FOMO), and the desire to get rich as early as possible are driving retail investors to SME IPOs.

“High market liquidity has fueled exaggerated price movements in smaller, less liquid SME stocks as investors chase high returns and disregard the underlying risk. The fear of missing out on quick gains has also spurred continued investment in SME IPOs,” Vaibhav Porwal, co-founder of Dezerv, observed.

Issuers of SME IPOs are keen to benefit from the upbeat market sentiment. Instead of raising capital from debt, they are taking the IPO route.

Unlike the mainboard, there are few checks and counterchecks on SME IPOs. Many SMEs without strong business models and sound fundamentals launch their IPOs, and retail investors are lured toward them for listing gains.

What is worrisome is that many retail investors borrow funds from banks or other sources to buy these IPOs. When the stock gets a flat listing, many of them suffer losses as they do not get the desired listing gains, while they have to pay off the borrowed funds with interest.

The blind bet

Ideally, before buying an IPO, an investor is supposed to understand the company’s business, financial conditions, and growth prospects, among other things. They should carefully review the company’s red herring prospectus (RHP) to get clarity about its fundamentals. However, experts say many retail investors bet on IPOs without having a clear idea about what they are buying.

“Retail investors see the subscription that has happened, the grey market premium (GMP), and who the merchant banker behind the issue is,” Arun Kejriwal, the founder of Kejriwal Research and Investment Services, observed.

There is simple mathematics behind the blind bet of retail investors.

As Kejriwal pointed out, the retail application on the mainboard is ₹15,000, which is one lot size. On the SME, this lot size varies from ₹1,10,000 to ₹1,30,000. If one takes an average of ₹1,20,000, the lot size difference between the mainboard and the SME IPO is eight times.

On a mainboard, if one gets an allotment, she will make 30-40 per cent of the ₹15,000, so her profit would be around ₹6,000. But in the SME, if she gets an 80 per cent return, her profit would be around ₹96,000. This explains the frenzy of retail investors for SME IPOs.

Key points that retail investors should know

Investors must be aware of the company’s business, financial conditions, competition, the objective of the issue, current trends in the industry and the company’s growth prospects before going for its IPO.

“Investors should see what the company does, what it intends to do with the proceeds, the numbers they are talking of, and whether such numbers are being earned by the companies which are listed on the mainboard,” said Kejriwal.

According to financial services firm Pantomath Capital Advisors, investors should consider the following key things before applying for an IPO:

1. Financial health of the company: Examine the company’s financial statements to see if it’s making money, growing, and managing debt well, said Pantomath. A solid financial base is key to future success.

2. Read the prospectus carefully: The financial services firm underscored that a company’s prospectus gives the full picture of the company—how it operates, its financial health, the risks involved, and what it plans to do with the money it raises. Understanding this will help investors know what they are getting into.

3. Understand market trends and industry: Consider the industry the company operates in and current market trends. Companies in growing industries often have better prospects, Pantomath said.

4. Competition: Look at who the company’s competitors are and whether it has a strong position in the market. A competitive edge can mean a more stable investment.

5. Valuation: Compare the IPO price to similar companies to determine whether it is reasonable. Pantomath underscored that an overpriced IPO might not yield the expected returns.

6. Lock-up periods: Find out if a lock-up period prevents insiders from selling their shares right after the IPO. This can affect the stock’s supply and demand, said Pantomath.

Apart from these key things, investors should try to find out if there are red flags.

“Look at the companies on the mainboard, look at their growth and performance, compare with the SME, and if you find in that SME company that the last three years have seen rocket growth think that it is an aberration; it is a cooked-up story and avoid it,” Kejriwal said.

Pantomath Capital Advisors pointed out that a lack of operational history or a proven business model can signal potential struggles with sustainable growth.

“Be wary of inconsistent financial projections, which might lead to unsustainable post-IPO performance. Controversial or inexperienced leadership can create uncertainty, while weak governance and poor transparency increase risk. Excessive debt can limit growth and flexibility, and overpriced valuations compared to competitors may result in losses,” said Pantomath Capital Advisors.

“Overly positive analyst reports might be biased, and significant recent changes in the business model could indicate instability. Rapid selling of shares by early investors might suggest underlying issues, and negative media coverage can erode investor confidence and harm profitability,” said the financial services firm.

Experts say Sebi should step in

It is wrong to see the IPOs of the SME segment in a bad light. To say don’t apply for an SME IPO is like saying one should not earn money. However, applying to every IPO without reading anything about the company could be extremely harmful.

Experts believe market regulators should initiate reforms to make the SME IPO segment more transparent.

“SME is meant for people with small ticket sizes. Why are companies bringing QIBs and anchor investors into the allotment process? It is a way to make money on the side. This is like exploiting the loopholes. A few handfuls of people are applying as anchors in QIBs. If exchanges do not revoke this allocation, SEBI should stop it,” Kejriwal said.

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