SEBI (Securities and Exchange Board of India) has issued a warning on SME (Small and Medium Enterprises) offers and listings to investors and there is cause for such caution even beyond stock manipulation by promoters. Here’s why.

An SME compared to a large player is like David versus Goliath. And in the real world, very few Davids ever overpower the Goliaths.

One needs to keep this in mind when evaluating investment in SMEs.

What’s more, investing in certain classes of assets requires different kinds of expertise and resourcefulness.

You therefore need to decide what you are cut out for, before deciding whether SME investments are for you or not.

But first, let’s understand the risks.

THE SCALE OF RISK

Only one of every 10 startups survives. What this means is that if you invest in a startup, chances are only one of 10 such bets will succeed.

In terms of risk, SMEs may be a tad better. And while there is no definitive data that I could find on insolvencies in SMEs alone, the banking sector data shows that 6-7% of SME credit turns non-performing each year.

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This means that about seven of 100 SMEs enters financial difficulties every year. Compared to this, very few large, listed companies become insolvent in a short span.

Hence, when evaluating SMEs, one should attach a higher risk premium to expected returns—and consequently lower valuation multiples compared to larger peers.

So, peer to peer, my guess is an SME should trade at a 30-40% discount to a large established peer.

ACCESS AND ABILITY

What’s most important when investing in a startup or SME is access and expertise in evaluating the prospects of such a business.

You are well aware that investors in startups go through several interactions with promoters and conduct due diligence before putting money in. They also get involved in helping grow the business and guiding the management team, especially if led by young professionals.

Such access along with investor expertise and intervention leads to odds that help such investors make money. Without this, 10 out of every 10 investments could prove duds.

In the case of SMEs too, the risks are high. So, access to the management, knowledge of their market reputation and standing, awareness about their financial strength as promoters and capabilities and business strategy are all important to be able to make an investment with a half good chance of gains. Without this, the odds are loaded against you.

QUESTION OF SCALABILITY

In any equity investment, the potential of the investee business to grow and acquire scale is extremely important. This separates the men from the boys.

For every Amazon and Flipkart, there are thousands of failed startups. The fact about business success is that only a few will make it to scale and thrive.

The big issue with the recent IPO of Resourceful Automobile that attracted a lot of attention on social media is the issue of scalability.

Also Read: Resourceful Automobile, the SME IPO subscribed 419 times, lists at issue price

The key issues to look at illustratively in this instance and for all such IPOs is: nature of business, scalability, profitability, potential for expansion and diversification, and peer business models and competitive intensity.

In the case of Resourceful Automobile, one must appreciate that the company is a dealer of Yamaha 2-wheelers with a small presence in one locality in Delhi.

Here, the first thing to consider is Yamaha’s prospects in the segment in India. Presently, it has the lowest market share among the non-pure EV players in the country. And the growth of the dealership hinges on the success of Yamaha, as the OE handles all marketing.

Next, the company being listed is the one that houses the Yamaha dealership. As a rule, no OE (original equipment manufacturer) will allow a business group to sell products of any other brand in a company.

So, this limits expansion of business with other brands under this company. This is unlike larger listed peer Landmark Cars which has 11 subsidiaries under the listed entity for partnerships with 11 OE brands including like Mercedes, Jeep, Honda, VW, BYD, KIA, MGM, M&M, and Ashok Leyland.

Hence, Resourceful Automobile has no future beyond Yamaha, though the promoter could start another company to sell another brand.

Also, margins in the dealership business range around 7% and that’s in line with the company’s historical figures and the last year numbers seem like an aberration, so any valuation model should ascribe a multiple accordingly.

The big question here is: can Resourceful Automobile be among the top 5 two-wheeler dealerships in the country? Presently, that seems like a no go, unless Yamaha works some big magic.

GOVERNANCE IN QUESTION

Little knowledge of the promoters and the quality of governance is the other big risk. Given this, it becomes extremely difficult to distinguish between good and bad eggs.

SEBI has clearly warned how promoters have been making announcements and using corporate actions to influence stock prices for their own gains in several SMEs. That’s a huge risk.

Also Read: A greed and no fear report from India’s manic IPO market

What’s more, you never know what the reported numbers hide. It isn’t difficult to cook the books and you could never know whether they depict the true picture unless you know of the auditor and her / his ethical standards.

SME OFFERS BEST LEFT ALONE

For the retail investor, dabbling in the SME segment is generally a no-no for all the above reasons.

It is better to earn a little less return than lose your capital. Leave the SME segment investments to investors in-the-know.

Happy investing!