Only Loss-Making or Overvalued Smallcap Stocks to Face Stricter Surveillance Under Revised ESM Framework

ESM Stage 2 Rules Revised: The Securities Exchange Board of India (Sebi) and Exchanges, in a joint surveillance meeting held on July 25, revised the criteria for shortlisting stocks and deciding their stage-wise progression under the Enhanced Surveillance Measure (ESM) framework. Under the new framework, only those stocks already placed in Stage I and trading at a price-to-earnings (PE) ratio of zero or below, or at a PE ratio exceeding twice that of the Nifty 500 index, will be moved to Stage II.

As of July 25, the Nifty 500 index's PE stood at 24.3, according to Trendlyne data. This means that only those small-cap stocks with a negative or zero PE, or a PE ratio exceeding 48.6, would qualify for inclusion in Stage II under the revised ESM norms, as long as it fulfills other shortlisting criteria.

The revised norms, which comes into effect from July 28 onwards, will be applicable to companies with a market capitalisation of less than Rs 1,000 crore, National Stock Exchange (NSE) said in a circular dated July 25.

Earlier, there was no defined valuation filter for moving stocks to Stage II, making this the first time a clear PE-based criterion has been introduced under the ESM framework.

Let's take a closer look at the existing criteria that exchanges use to identify stocks for inclusion under the ESM framework.

Criteria For ESM Stage I

Smallcap stocks that show unusually high price volatility over a three, six, or 12-month period is identified based on specific criteria.

If a smallcap stock, having a market capitalisation below Rs 1,000 crore, shows either a sharp swing between its highest and lowest prices or a big change in its closing price over the said period, and the movement exceeds one standard deviation compared to its peers, it gets flagged under ESM Stage I.

Once a stock enters in ESM Stage I, it faces 100 per cent margins, trade-for-trade settlement, or tighter daily trading price band of 5 per cent or 2 per cent, in case a stock is already in the 2 per cent band.

Stocks on which derivative products are available are excluded from the process of shortlisting, as per NSE's circular.

Volatility is measured after adjusting for corporate actions like splits or bonuses.

Criteria For ESM Stage II

A stock already placed under Stage I of the ESM framework will be moved to Stage II if it sees a 15 per cent or more price gain over five consecutive trading days, or a 30 per cent or more gain over a one-month period.

If a stock meets either of these price movement criteria, it will then be assessed against the new valuation filter. Only if the stock's PE ratio is zero or below, or exceeds twice the PE ratio of the Nifty 500 index, will it be moved to Stage II.

A PE ratio of a stock or index is calculated by dividing the market price per share by the earnings per share (EPS). When a company reports a net loss, its EPS turns negative. As a result, dividing the share price by a negative or zero EPS gives a zero or negative PE ratio, which means the company is loss-making.

What It Means For Investors

With this revision, shares of smallcap companies that are profit-making (PE ratio above zero) and are fairly valued (PE ratio below 2x of Nifty 500 PE) will get a breather from the strict ESM norms, even if they face extreme volatility in their prices.

This can help avoid unnecessary panic selling among retail shareholders when stocks are moved into surveillance just because of short-term price swings. This will also give a fair chance to fundamentally stable companies for better price discovery, without any hindrance of ESM norms.

NSE emphasised in its circular that the shortlisting of securities under ESM is purely on account of market surveillance, and it should not be construed as an adverse action against the company concerned. The Exchange will publish the list of stocks shortlisted as per the revised framework shortly after it comes into effect from July 28.

How And When Stocks Can Exit ESM Framework

The Stock Exchanges reviews ESM-listed stocks every week to check if they can be moved to a lower stage or completely removed from the framework.

A stock is eligible to exit the ESM framework after 90 calendar days, provided it no longer meets the criteria that got it flagged in the first place.

If a stock is in Stage II, it must remain there for at least one month, even if it qualifies for exit. After that, if its price movement over the past month is less than 15 per cent, it may be moved back to Stage I in the next weekly review.

Once a stock exits the framework, its price band will return to the level it had before being put under ESM, unless the stock is under any other surveillance measure, in which case that price band will continue to apply, NSE clarified in its circular.