SME platform is an exciting new avenue in Indian markets. This is where small, young and dynamic companies are traded publicly. In developed markets, small and growing companies are bought by their larger peers even before they go public so investors never get to own shares of these companies. In India, promoters are unwilling to sell their companies to larger peers and instead choose to sell only a minority stake to small and distributed investors so there are plenty of small companies that are trading publicly.
SME companies grow at a high rate and tiny in size (I think average market cap is somewhere around 50 cr) so even regular investors get the same returns as private equity investors with an added advantage of an easy exit option if things don’t work out. The big irony is that small investors are not allowed to in invest in small companies as lot size is usually 2000 to 3000 shares. This is because these are risky and SEBI assumes that small investors are not capable of handling the risk. Even then, the minimum purchase lot is around 1 to 3 lakhs so it is not totally out of reach of small investors.
Most of SME companies go public at around 2 times post issue book value and around 6 to 10 times earnings. This is much better than aggressive valuation of main board companies.However, only 1 out of 20 SME issues is worth investing so you have 95% chance of picking the wrong one. This is what makes them unattractive and keeps the overall valuation low but it also enables a careful and hardworking investor from earning huge returns.
An SME company moves to main board of the exchange once the market cap crosses 200-500 crores (this is just my observation, correct me if I am wrong here). That’s when liquidity improves. Considering that average market cap is around 50 cr, the company has to go up 4x to 10x before it will move to main board. I am sure lot of SME investors invest in SME issue with an expectation that the issue will move to main board.
Typical characteristics of SME companies that are worth investing (1 out of 20)
- Young and dynamic companies
- Fast growing companies earning high return on capital
- Typically founded by first generation entrepreneur.
- Offered at reasonable valuation relative to growth rates.
- Institutions generally are not interested as size is too small for them.
- Simple businesses, no conglomerate structure.
- IPO prospectus has detailed information about the company.
- Business model is not proven.
- Commodity business, no moat or competitive advantage.
- Growth and return ratios can drop as size increase
- poor liquidity as lot size is large.
- price can be very volatile.
- likely to drop substantially in a bear market.
- Most SME issues are bad. One has to be very careful in picking the right one.
Here are some of the issues that I have invested recently.
Worth is a manufacturer of corrugated boxes. It supplies packaging boxes to FMCG companies. It has a manufacturing capacity of 30,000 tons with a capacity utilization of 90%.
- Relatively new assets (plant is built in 2012) and automated manufacturing.
- Return ratios are good. Cashflow is good.
- Opportunity size is large as packaging industry is growing.
- Company has been able to pass on price increase to customers so margins are stable.
- Young and first generation entrepreneur. My interaction with management showed that management is genuine.
- Capacity is almost fully utilized. no room for further growth. Company plans on raising additional capital to fund capex once it moves to main board. this may or may not happen. It may not move to main board unless market cap rises which may not rise unless profit rises which in turn may not rise until capacity/production rises.
- Kraft paper prices can be volatile and company may not be able pass on all price changes to customers.
- IPO is for working capital and benefit of listing only and no new capacity is being created.
My only rationale in investing in this company was a good company offered at low valuations. Since growth visibility is not there, I am already considering to sell as price has already doubled. However, this is selling at fair value now.
RM Drip and Sprinkler Systems
RM Drip is a manufacturer of micro irrigation systems. Company manufacturing units are set up in 2015 and 2016 so utilization is around 25%. Sales are growing at 100% in last 2 years as new units are set up. company’s fortunes have brightened once Mr. Shyam Dash joined the company in 2015 and became director in 2016.
- Fast growing company
- New capacities with low utilization. Likely to improve over next two years
- Margins are better than competitors and growing.
- Company’s customers (farmers) depend heavily on government subsidies.
- 25% of business comes from project market where company installs MIS and files a claim with the government for reimbursement. This is a working capital intensive business as payment from govt can take 4 to 6 months.
- No competitive advantage as products are commodity. Only distribution and pricing is the differentiation.
- Competitors (EPC Industrie - Mahindra group, and Jain Irrigation) are large with strong distribution.
- Cashflow is poor. However, given the growth rate, this is OK.
RM Drip is offered at 2 times post issue book value and 28 times TTM earnings. Issue appears expensive but company is growing rapidly so earnings should catch up quickly. By my estimate, company is trading at around 13 times FY 2018 earnings.
Shanti Overseas (India) Ltd.
Shanti is a trader turned manufacturer of Soya products like soyabean meal, soyabean oil and soyabean lecithin. Shanti has been a trader and primary processor of agri commodities until 2014. Since 2015, it signed an agreement with Bushman Organic Farms (US) for supply of organic soya meal. Bushman is a supplier of organic animal feed in US. Growing preference of organic food in West is driving demand for organic animal feed. As per US law, animal has to eat organic feed to be certified as organic meat.
Company has started crushing plant of 24,000 TPA capacity in 2015 and is planning to increase it to 36,000 TPA using IPO proceeds. It is also going to set up 18,000 TPA oil refinery.
Agreement with Bushman and planned new capacity provides growth visibility
Capacity is new and utilization will improve over next two years.
Organic meat is growing in popularity in West.
India is the only country in world that exports non-GMO soyabean so Indian soya meal should command a premium in organic feed market.
ROE is high but likely to drop as leverage comes down.
- Company does not use any solvent for extraction which is necessary to maintain organic tag but it results in lower yields and higher costs.
- company is highly leveraged.
- Agreement with Bushman prevent company from selling organic soyameal to anyone except Bushman that is produced from mechanical expeller machines.
- Company has no experience in manufacturing. It has been a trader for over a decade.
- Industry is highly fragmented and competitive. Few organized players are significantly larger than company.
- company’s margins are significantly higher than competitors so there is a risk that margins may drop.
- Shares are trading 30% below issue price so investors are not enthusiastic about company’s prospects.
- Soyabean prices are volatile and farmers may decide not to produce soyabeans reducing plant utilization.
Shanti Overseas is a direct play on growing popularity of organic meat in US. Whether this turns out to be a trend or fad will decide fate of the company. Valuation is cheap at 7 times earnings and 1.4 times book value.
RKEC Projects is a construction company that specializes in marine infra, bridges and roads. company has made good progress in last 2 years and appears to be at an inflection point. Company is promoted by a first generation technocrat promoter.
- For a construction company, balance sheet is strong.
- Looking at list of past and present customers, company appears to be moving from an L2 contractor to an L1 contractor which should help improve margins.
- Opportunity size is large.
- No BOT portfolio. 0% captive order book.
- Current orders are worth 700 cr compared to sales of 190 cr in FY 2017. this provides revenue visibility.
- Market cap is already 200 Cr so this issue is likely to be moved to main board.
- Company’s return ratios have only improved in FY 2017. Whether these are sustainable or one-hit-wonder is yet to be proven.
- Business is working capital intensive.
- Executive compensation is high. Business is highly dependent on promoter.
RKEC was offered at low valuations however shares have quickly gone up since IPO so company is now fairly valued.
I generally take growth opportunities of SME companies with a pinch of salt as there is no assurance that company will be able to capture these opportunities. SME issues are not a macro story. It is very much individual stories that can play out (or not) irrespective of overall economic situation.
Disc: There are many SME IPO issues and I may sell any or all of these if I find something better. This is not an investment advice. Please do your own due diligence.