As SEBI, RBI join hands to curb liquidity, small & midcap shares may face the heat

The action against JM Financial, in particular, rattled the stock market

Small and midcap shares recovered from Wednesday’s steep fall, but individual investors—both high net worth and retail—have become guarded about these stocks.

This follows a series of actions by market regulator SEBI and banking regulator RBI, over the last week, with at least one of it being a joint effort.

What seems evident from their words and deeds is that the regulators are trying to check the deluge of money that is leading to bubble valuations in the stock market.

The small cap frenzy

SEBI set the ball rolling last week when it nudged mutual fund body AMFI into putting brakes on the rapidly small and midcap equity schemes. While AMFI issued the circular to it member mutual funds, it cited SEBI’s observation of a froth building up in small and midcap shares. Various small and midcap indices have risen between 50-70 percent with prices of many stocks doubling or trebling.

It is highly unusual for a regulator to mention the word ‘froth’ considering that valuations are for the most part subjective. That it chose to say it explicitly reflects the regulator’s unease at the rapid rate at which stock prices have been rising, much of it fuelled by domestic inflows.

Market view

“SEBI has handled the situation well by putting the onus on AMFI, which in turn has put the ball in the court of the trustees,” Shyam Sekhar, founder of Financial Consulting told Moneycontrol.

“The writing on the wall is clear. Mutual funds must be increasing the cash positions in their small and mid cap schemes,” referring to the sell-off seen on Wednesday.

Sekhar is of the view that much of the froth in small caps is man-made.

“Even now there is no consensus among mutual funds about moderating inflows, some of the (small cap) schemes are still accepting inflows as before. Like investors, the (mutual fund) industry too is suffering from FOMO (fear of missing out),” he said.

The lion’s share

In 2023, midcap mutual fund schemes got inflows of Rs 22,913 crore, and smallcap schemes got Rs 41,035 crore. On the other hand, largecap schemes saw an outflow of Rs 2,968 crore.

The numbers are a testament to retail investors' eagerness to be part of the stock market action. But it also raises questions about the scenario when too many investors would want to exit at once. This was seen during previous market meltdowns in 2008 and 2020.

“Sebi is only concerned about mutual fund’s ability to handle redemptions if there is a sudden turn in sentiment and investors come to redeem,” said A Balasubramanian, CEO, ABSL Mutual Fund, on the SEBI advisory to AMFI.

“Valuation risk no one can do anything; the market determines that. All Sebi can do and is doing is to make sure that mutual funds handle the risk well,” he said.

Small and mid cap shares took a beating on the day the circular was issued, as market worried about AMFI’s directive to mutual funds to moderate inflows and rebalance portfolios. However, over the next couple of days, it was business as usual.

Enter RBI

Then came RBI’s actions this week, first against IIFL Finance asking them to halt giving gold loans, and then next against JM Financial the following day, directing them to suspend loans against shares, including IPO financing due to deficiencies in its processes.

The action against JM Financial, in particular, rattled the stock market as it had a direct bearing on liquidity. Interestingly, the central bank carried out a limited review of the processes at JM based on information shared by SEBI.

RBI has said that JM’s credit underwriting for its IPO funding business was found to be “perfunctory,” financing was done against meagre margins, and that the client bank accounts were operated using Power of Attorney (POA), which was illegal.

In other words, JM Financial was helping increase the number if bids for IPOs by loaning money to customers without the requisite credit worthiness.

The fall out

This triggered another round of selling on Wednesday in mid and small cap stocks, as the market fretted about further action by RBI against erring NBFCs.

On its part, JM Financial defended the practice of taking POA as a risk containment measure, saying it was common across the industry and legal.

But the temporary ban—both on loan against shares and IPO financing—is making both NBFCs and HNIs jittery. Talk in the market was many NBFCs were holding back on fresh loans against shares and reviewing their accounts.

“Recent customers have to comply with every RBI rule, but for the older clients with a long-standing relationship, NBFCs routinely overlook some of the rules,” said an HNI who invests in borrowed money. “That is now coming to haunt the NBFCs as the RBI is reviewing processes,” he said.

The RBI actions, coming close on the heels of the SEBI advisory to AMFI, have made investors wary of buying into mid and smalcap stocks with the same fervour as before.

There is no saying who is next in line for a rap, seems to be the common view on the street.

“Perhaps the RBI could have informally spoken to NBFCs and asked them to defuse the situation,” Ajay Srivastava of Dimensions Consulting told Moneycontrol.

“Such strict actions will have implications for liquidity in the system as HNIs may not find it as easy to access funds from NBFCs in the past,” Srivastava said.

The ED booster

Though unrelated, the SEBI and RBI seem to be getting some help from the Enforcement Directorate (ED) in tempering the frenzy in second-line shares. Last week, the ED froze Rs 581 crore shares held by associates of entities beneficially owned by Hari Shankar Tibrewala, a Dubai-based hawala operator with alleged links to the promoters of illegal online betting website Mahadev Online Book.

During the probe, the ED found that Tibrewala through his Dubai-based entities was investing the betting proceeds in the Indian stock market through entities structured as Foreign Portfolio Investment (FPI) structure. He had also employed many of his associates as directors in various companies to layer the betting proceeds by investing them in those companies. Some of the stocks which have Tibrewala-controlled entities like Zenith DMCC and Tano Investment Opportunity Fund as investors, have risen multifold over the last couple of years.

Some of the stocks have taken a beating following the development, but others continue to rise.

Road ahead

On Wednesday, the number of declining stocks outnumbered advancing stocks by more than 3:1 even as the Nifty and Sensex hit record highs. The following day, the number of advancing stocks were higher, but not by much—12 stocks rose for 10 that fell.

But is early to say if the regulatory actions will have the desired impact anytime soon, given the ample liquidity in the system and the robust macroeconomic fundamentals and corporate earnings.

“Small- and mid-caps had already rallied a lot and were looking ripe for a correction. The regulatory vigil only comes as a coincidence at a time when stocks are already overpriced,” Nilesh Shah of Envision Capital told Moneycontrol, adding that many of these shares have been under pressure since the start of this year.

“The weakness seems more like a March phenomenon when investors want to lighten up their portfolio,” he said.

“Many corporates, family offices, and funds have taken short-term positions which they may want to square off their positions. They may also want to book losses for tax planning purposes,” Shah said.