The Small-Cap Mini Crisis

In today’s Finshots we talk about the BSE circular that may have caused a mini-rout in the small-cap universe.

The Story

For the uninitiated, there’s been a massive rally brewing in the small and mid-cap segments i.e. stocks that aren’t really huge. On most occasions, their market capitalization hovers anywhere between a few hundred crores to about 20,000 crores. But the rally is more apparent as you go down the rung. And when you’re looking at small companies with a market cap of a few hundred crores, you’ll start seeing some crazy stuff happening.

Consider, for instance, this excerpt from an article in the Indian Express published last year

Retail investors’ frenzy over small stocks in India has reached such extremes that shares of some companies that aren’t booking any sales, let alone profits, are going through the roof.

These include Transglobe Foods Ltd., a fruit-jam maker that has skyrocketed more than 4,300% this year, and real-estate services firm Shree Precoated Steels Ltd., which has jumped over 1,300%. Both companies booked losses on no sales in the latest fiscal year.

Now you could argue that retail participants know something about these stocks that nobody else does. But in all honesty, that’s probably not an accurate assessment.

In many cases, you’ll see that rallies of these kinds are primarily driven by a group of individuals who are dabbling in small quantities. It’s like this — If only a few stocks exchange hands, it’s likely you’ll witness a massive fluctuation in prices. Imagine just the two of us trading a stock — You want to buy a stock at a 10% premium and I sell it to you at the price. All of a sudden, the last traded price jumps up by 10%. So with small volumes, you could artificially drive prices higher.

In some cases, you could ever hire stock operators who will use an elaborate network of dealers and professionals who will bump up the prices artificially and then offload them to the general public once the price becomes attractive. There is always a retail investor looking to make a quick buck off of “stocks-on-the-rise” and once the dust settles they are often left with a dud stock that is pretty much worthless.

So the Bombay Stock Exchange thinks it can do something about this. And on that note, they released a circular detailing how they’d impose price caps if they witness a sudden abnormal interest on any particular stock. For instance, if a stock has rallied 6 times or greater over the past six months, 12 times over the last 12 months, 20 times in over two years, and 30 times in three years, they’d be subject to special price limits i.e. if you intend to buy or sell these stocks then you will have to contend with a weekly, monthly and a quarterly limit, in addition to a daily price limit.

What’s the daily price limit you ask?

Well, with most stocks you have a circuit limit of 2–20%. Meaning if the price does breach this threshold, then you can’t trade with that stock. However, with the new circular in place,  you have another condition where you’ll see a bunch of stocks being subject to weekly, monthly, and quarterly limits as well.

In fact, the moment people realized trading could be restricted in a select set of stocks, there was a sell-off. People panicked and prices of small-cap stocks tumbled. There were others who even criticized the move citing the needless intervention. And soon enough, BSE was forced to update its circular. They added that the restrictions would only be imposed on an even smaller group of stocks (belonging to X, XT, Z, ZP, ZY, Y groups), with a market cap of less than 1,000 crores and a price greater than Rs. 10.

Thereby reducing the pool of stocks that would have been impacted by the diktat.

So yeah, bottom-line — BSE doesn’t want the small cap market to overheat and explode and they’re willing to intervene at some level, if it means protecting the interests of unsuspecting retail investors.

Until then…

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Point of Interest: The letters X, Z, ZP denote a classification criterion. For instance all stocks part of the Z group have failed to comply with listing requirements and/or have failed to resolve investor complaints.