Opinion | Five policy decisions that led to the mid, small cap stock sell-off

This dichotomy has now come to the notice of the market regulator, the Securities and Exchange Board of India (SEBI), which is looking into the crash in share prices of small and mid-cap companies in recent months. A significant portion of the fall can be attributed to the side effects of decisions taken by the regulator and the finance ministry.

While these decisions have been taken in good faith in order to plug certain lacunae in financial regulation, they have ended up scaring away investors. Here’s a look at five of them.

- Long-term capital gains tax (LTCG): Finance minister Arun Jaitley and his colleagues may have congratulated themselves for plugging one more avenue of laundering black money by introducing the long-term capital gains tax. But this announcement has been partly responsible for the selloff in small and mid-cap stocks.

- Mutual fund reclassification: In October 2017, SEBI asked mutual funds to group their equity schemes under large, mid and small caps based on market capitalisation and cut down their number of schemes. The regulator’s intention was good as there was duplication of schemes and a need to restore order.

However, nearly half the schemes had to be readjusted in a small window of 3-4 months. The definition change also caused churning and selling of smaller companies, irrespective of the fundamentals or the outlook on these stocks.

According to Sebi, the first 100 stocks ranked by market capitalization went in the large-cap basket, the mid-cap basket was for stocks with a ranking from 101 to 250, and small-cap (stocks below 251). This strange segmentation resulted in unnecessary churning and selling smaller stocks.

After this rule was introduced, fund managers were busy realigning their portfolios and trying to get out of illiquid stocks without causing too much damage to fund performance. The forced selling of illiquid stocks pushed the price of these stocks lower. With no institutional buyers present to provide a cushion, share prices went on a free fall.

- Additional surveillance: In May 2018, SEBI stepped up its scrutiny on a set of stocks through the so-called additional surveillance measure (ASM). This, however, added to the mayhem as there seemed to be no logic in the selection of stocks.

Though SEBI insisted that the curbs were based on market surveillance, market rumors persisted that these stocks were selected on poor fundamentals. Investors stayed away from smaller stocks as there was no clarity on which stock would be picked up to be under ASM. This move was not taken well by the broking community which asked the regulator to constitute a new committee to look into the issue.

- Auditor resignations: A spate of resignations by auditors of mid-cap firms added fuel to fire. According to data from the ministry of corporate affairs, as many as 204 auditors have resigned this year till 17 July.

Earlier this year, the government announced that it would set up a separate regulatory body for auditors, a move that resulted in auditors pulling up their socks.

In many, though not all, cases of resignation, auditors moved away after their client companies refused to abide by the rules and continued to furnish incomplete information on their books. As a result, investors started questioning the numbers that the companies were showing and preferred staying away.

- Physical settlement: SEBI introduced physical settlement in 46 illiquid, small companies in the derivatives segment. The rules, especially the tax part, were unclear. As a result, many brokers started advising their clients to stay away from such stocks till there is clarity.

In conclusion, the question now is whether the stocks that have been rising will come down or will small and mid-caps rise to participate in the rally. The market mood suggests the former.