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What is the SME exchange? Should you invest in companies listed on it?

We all have heard about the NSE and the BSE. But you may also have come across the 'SME' exchange in the media. Here's all you need to know about it.

What is the SME exchange? Should you invest in companies listed on it?

Have you ever wondered about investing in start-ups, more specifically a stock that will give you multifold returns? Here, we are not talking about investing in venture capital or private-equity funds, which generally invest in many early-stage companies out of the belief that at least one of them will give terrific returns. Instead, our focus is on companies that are listed in an SME Exchange.

What is an SME exchange?
A company has to meet some criteria laid down by the SEBI to get its shares listed on a regular stock exchange. These include having an operating profit of Rs 15 crore in the last three years, the minimum post-issue market cap of at least Rs 25 crore, etc. But over a period of time, the need to allow even smaller/younger companies to raise money from the public through the capital markets was felt. Thus, such companies, referred to as SMEs (small and medium enterprises) were allowed to raise capital in a separate trading platform, wherein the entry barriers would be lower. This trading platform is called an SME exchange.

Interestingly, it is not a separate exchange like the BSE or NSE. Instead, it is a separate trading platform within the main stock exchanges, where shares of SMEs are traded. So, the name, SME exchange, is a bit misleading.

Since the BSE and NSE operate SME exchanges (called BSE SME and NSE Emerge, respectively), investors who can transact stocks in regular exchanges can automatically purchase shares in SME exchanges.

Difference between SME and regular exchanges
An SME exchange and a regular stock exchange broadly differ on two things - requirements for the listed entity and investors' characteristics. In order to pave the way for a wide range of SMEs to get listed, the SEBI has eased regulatory requirements, such as a lower minimum paid-up capital (Rs 1 crore), fewer number of allottees, etc. Besides, post listing, there are fewer compliance requirements that companies need to adhere to.

On the other hand, when it comes to investors, the SEBI has adopted a very cautious regulatory approach wherein it has tried to encourage only high net-worth investors (who tend to have a larger risk appetite) to invest in companies listed on the SME board. So, potential investors, during the Initial Public Offering (IPO), need to apply for shares worth at least Rs 1 lakh and even investors in the secondary market need to buy shares worth at least around Rs 1.5 lakh. Hence, small-time investors are prevented from investing in these risky companies.

Should one consider investing in companies listed on an SME exchange?
Like many answers to the questions related to investment decisions, the answer to this question is - it depends. While it is possible to make outsized returns by investing in these companies, this comes along with a higher degree of risk as well. Smaller companies have untested business models and are more vulnerable to shocks in their respective operating environments. Also, the lower disclosure requirements can be a double-edged sword, as investors may not be able to spot negative trends early. And finally, liquidity should also be factored in. Out of 236 companies listed on BSE SME and 125 on NSE Emerge, companies outside around top 50 hardly see any trades at all. And even the top 50 companies have extremely low volumes. And this is perhaps the reason why there are no funds based on the NSE SME Emerge Index, which has given a CAGR of 11.4 per cent in the last four years (as on December 31, 2020).

Investor takeaways
For most retail investors, it is better to stay away from this space. Investments in these companies are inherently riskier, owing to the lower levels of liquidity, information disclosure and higher ticket size. But with that being said, the fundamental principles of identifying investment opportunities are applicable just as much to SMEs as they do to large corporates. Investors should pick companies that are likely to grow their profits, have a good track record, operate in non-competitive segments and pay a sensible price that incorporates a margin of safety. If you don't want to spend time doing research, you can consider subscribing to Value Research Stock Advisor, which gives you a list of stocks that fulfil all the above-mentioned criteria. Investors must realise that just because a company is listed on a particular exchange, it doesn't mean anything. There is no substitute for thorough research.