The penny drops

Small cap stocks were the worst- hit during the selling in the markets last week""the BSE Small Cap index lost 11.19 per cent, while some penny stocks fared even worse.

That's hardly unusual because, since floating stock is low, it doesn't take much to move these stocks sharply. Small cap stocks had run up far more than the frontline scrips in the rally, and the market is rife with rumours of price rigging and collusion between unscrupulous promoters and operators. Given the degree of volatility in many of these scrips, and the fact that many "small investors" have invested in these stocks, does there exist a case for special regulatory oversight?

Actually, the Securities and Exchange Board of India (Sebi) has been pro-active during this rally, and it has been quick to move scrips which show unusual movements to the trade-to-trade category (where taking and giving delivery is compulsory) and in requiring higher margins.

It has also acted swiftly in using circuit breakers, although there is some debate on their efficacy. The point is, the market regulator has been using the market instruments available to it sensibly.

Clearly, however, that hasn't stopped the sizzling run-up in penny stocks, many of whose fundamentals are suspect. This has led to suggestions that stocks in the Z category""stocks of companies that haven't complied with the listing requirements""should not be listed at all.

That seems to be a fair argument, since there's no reason why a company should continue to be listed if it doesn't comply with the rules, other than for allowing its minority shareholders an exit. If another way of exiting the stock can be devised for these shareholders, there's no reason why the Z category stocks should continue to be listed.

Also, Sebi needs to set an example by pursuing and punishing a few high-profile cases of market manipulation in small stocks, which will deter other manipulators. So far, Sebi has been singularly unsuccessful in this regard.

At the same time, the obsession with protecting the so-called "small investor" can be taken too far. Investors in penny stocks often know very well the dangers that they are exposed to.

It is greed for the extraordinarily high returns that can be reaped by speculating in penny stocks that drives them""their horizons are usually extremely short-term, and they can hardly be called investors at all. It also needs to be remembered that while the number of such stocks may be large, their share of market capitalisation is very small.

The stocks comprising the BSE Small Cap index, for instance, account for just 6 per cent of total market capitalisation. It's clear therefore that while irregularities in these stocks need to be investigated, they do not pose any systemic risk, and consequently need not take up a disproportionate amount of the regulator's time.

As for the gullible few who have been genuinely trapped by smooth-talking brokers, all that can be done is to educate them about the dangers of investing on the basis of market tips.

The "small investor" should also be told about the advantages of using the mutual fund route to invest in the stock markets, and there is much that the Association of Mutual Funds of India can do in this regard. Beyond that, all that can be said is "Caveat Emptor".