Amey Kulkarni runs a blog by the name Candor Investing(https://candorinvesting.com/). He also has firm grip over forensic accounting and his website contains some brilliant articles on the same.
Please find key points of his session below. (Selection and Emphasis ours)
The talk tries to summaries one of the key topics in our Indian financial system. The talk features, what is a good lending business? One of the questions that the speaker tries to engage with during the talk is, what is relatively easy?
Sales of loans or recovery of loans; he says if we look at the data of 5 year CAGR of sales (for banking stocks) and compare it with the returns (market value) on those stocks, there is no causal link that if sales is high Markets will give you high valuation.
On the other hand he looks at the Gross NPA and 5-YR-returns CAGR and sees if there is a causal link between these two metrics. After looking at the figures the author presents, which shows that when the Gross NPA is low, i.e. lower than 2%, than the 5 year returns range from 18 to 25 to 32%, which means that if Gross NPA is low than the Market valuation is high.
Similarly when we look at the companies which have a very high Gross NPA than the Market valuation give to those companies is very low. If the Gross NPA ranges from 7% to 8.7% than we see that the highest returns are of 11% (there is also a situation of negative returns).
The observations that we can make out of this is that stock returns are determined by how good the lending business is in recovering loans, not giving out loans.
Then he presents one of the formidable challenges related to banking system which is that consistently the Public sector banks have failed to what we have observed important to generate higher market valuations is recovering loans. (Look for a business which is good at recovering loans)
One astonishing fact that he shows through the graph is that, if you applied the theory of buying the business which is good at recovering loans back in 2005 (HDFC bank price was Rs 54 in JUN-05) and just sit through that decision than the 1 Lakh invested during that time could have resulted into 23 Lakhs currently (As of Dec-2019 the HDFC bank stock price was 1252).
Another stock that he mentions which grew due to the Low Gross NPA is City Union Bank. He says the City Union Bank grew from 5.5 Rs in 2005 to 230 Rs in December 2019 (which effectively means that if you invested 1 Lakh in 2005 than that would have grown to around 42 Lakhs till 2019).
Valuation of lending businesses:
The most common Valuation metric used in the valuation of lending businesses is the Price to Book Multiple. P/B varies from 11 for Bajaj Finance to 0.5 for Yes bank.
Companies use the price to book ratio to compare a firm’s market capitalization to its book value. It’s calculated by dividing the company’s stock price per share by its book value per share. An asset’s book value is equal to its carrying value on the balance sheet, and companies calculate it netting against its accumulated depreciation.
He talks about what causes a high and a low P/B multiple. He explains the situation of high and a low P/B multiple through different scenarios of return on equities and Gross NPAs.
He says that if the P/B ratio is greater than 2.5 than it maybe because of either high return on equity or Lower Gross NPA or both. He says that except ICICI bank the market gives higher P/B when the bank has lower gross NPA and Higher Return on Equity.
Same way he takes the example of P/B less than 2.5 and compares that to Gross NPA and Return on Equity. He says that in most cases when the P/B is less than 2.5 it is due to higher Gross NPA and lower Return on Equity.
Valuations of the Lending Businesses depend on two factors; one is Return on equity and the other is Gross NPA and its trend over a period of time.
Does Growth of a Lending Business matter at all?
He says that up-till now we have looked at the Gross NPAs as a key metric to assess the quality of lending business.
Another key question that he tries to ask is whether the growth is necessary in the lending business. To address the question he takes different scenarios. In scenario 1 he says that if ROE (Return on equity) is 10% and the lending business can borrow 9 times its own equity and all the profits are re-invested in the business. Then in the example if equity capital is 10 crores and if I borrow around 90 crores and give loans of 100 crores than my profit comes around 1 crore given the ROE of 10%.
Now in the other scenario if the ROE grows by 20% than if the equity capital is 11 crores and borrowed amount is 99 crores and the loans are 110 crores. Now because ROE is 20% the profit comes out to be 2.2 crores.
The observation that comes out of all this is that if the return on equity is 20%, the company can grow by upto 20% the next year. If the company tries to grow faster than 20%, since it can only borrow 9 times its own equity, it will have to raise more equity capital. This will dilute the returns of the existing shareholders. Thus, an investor can hope to make a maximum return which is equal to average ROE (return on equity) over the long term.
How to differentiate between a good and a bad lending business?
Financial crises will always be instrumental in separating good company from the bad. The speaker says that it is good that the company like IL&FS is downgraded to reflect the reality of what has gone through. When the company like IL&FS comes under a scanner it is a natural form of worry for the debt investors.
Aftermath of the IL&FS bankruptcy
Short-term debt markets literally froze.
Refinancing became difficult for even the good-quality NBFCs
There was a crisis of confidence
Several NBFCs like DHFL, Reliance Home Finance went bankrupt because bankers stopped additional loans.
In such a scenario, what is the Litmus test for lending businesses: Is the Lending Business able to grow its loan book when there is liquidity squeeze in the market?
He talks about how even after the crises that ensued due to IL&FS; companies like Bajaj Finance, Repco Home Finance, Canfin Homes were still able to grow their Loan Book.
So because of the crises and other headwinds the companies still came out being resilient. Companies like Bajaj Finance gave stock returns of around 39%, Mannapuram gave around 53%, Muthoot Finance gave around 66%, Canfin Homes were able to grow 25%.
Now he is talking about the companies which faltered after the IL&FS crises. He says some of the companies had to shrink their loan book because of the crises.
He gave examples like Piramal Enterprises which had to reduce their loan book from 4883 to negative 792, PNB Housing reduced the loan book from 4511 to 1890, Edelweiss had to reduce the loan book from 4118 to negative 2240, Shriram transport finance had to cut the loan book from 4176 to negative 761, Shriram City Union Finance had to cut the loan book from 1213 to negative 7, L&T finance had to cut their loan book from 4713 to 2264.
So as the Loan book declined so did the Stock returns. All the companies mentioned above saw the haircut on their stock returns; Piramal enterprises showed a decline of 42%, PNB housing showed a decline of 61%, Edelweiss showed a decline of 56%, Shriram transport showed a decline of 16%, Shriram city Union showed a decline of 33%, L&T finance showed a decline of 35%.
Parameters to judge lending businesses
a) ROE – Return on equity (consistency over a period of 5 to 10 years);
b) NPAs- Non-performing assets and its trend over several years;
c) Credit Loss: what part of NPA is actually recoverable and what can be written off;
d) Capital Adequacy Ratio: The capital adequacy ratio is a measure of how much capital a bank has available, reported as a percentage of a bank’s risk-weighted credit exposures. The purpose is to establish that banks have enough capital on reserve to handle a certain amount of losses, before being at risk for becoming insolvent. Capital is broken down as Tier 1, core capital, such as equity and disclosed reserves, and Tier-2, supplemental capital held as part of a bank’s required reserves. A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest solvency. Therefore, the higher a bank’s CAR, the more likely it is to be able to withstand a financial downturn or other unforeseen losses.
What type of a lending business to choose as an investment?
One way to invest in these businesses is to take a steady performer approach. Invest in a steady performer- HDFC Bank, Kotak Bank, Bajaj Finance, Manappuram Finance, Muthoot Finance, etc. They will help generate consistent moderate returns. This is a no-brainer strategy, but one has to take valuation risk- most of the good lending businesses are at historically high valuations.
History of Recent financial crisis in India
a) Global Financial Crises: Started with the sub-prime mortgage crisis in the US, Quickly spread across the globe, Stock prices of companies like HDFC bank dropped by 50% +
b) Microfinance Crisis in Andhra Pradesh: Several suicides reported in Andhra Pradesh due to “tactics” used for recovery of microfinance loans, State Government passed a law putting restrictions on Microfinance
c) Gold Loan Crisis (2012): Gold loans business grew very fast because of a massive bull-run in gold-prices (2001-2012). RBI changed its hands-off regulation policy on gold loan NBFCs. RBI added several rules/regulations on operation of gold-loan NBFCs.
As seen above, there have been periodic crisis in the financial sector in the past. Every time there is a crisis, the entire sector/sub-sector suffers. Only the strong amongst the pack survives.
Those who survive do extremely well over the next several years because of reduced competition. The pattern repeats with regular certainty
IL&FS crisis is one such opportunity to pick lending businesses which survive and thrive in the future.
Banks are far more stable businesses because RBI not only has strict regulation, but also acts as the lender of last resort.
It is only the NBFCs which have suffered after the IL&FS crisis, not the banks.
What kind of businesses do well into the future?
a) Those that have pricing power- they can increase interest rates in response to increase in cost of funds without fear of losing customers. E.g. Microfinance, gold loan, home loan (self-employed)
b) Have consistent high return on equity (ROE) with low leverage (high capital adequacy ratio).
c) This will help them grow fast in the future and absorb any temporary spikes in NPAs
d) Good track record of containing/managing NPA levels
A Case Study Repco Finance:
Market Cap: 1816 Cr. Loan Book Composition: Salaried was 44% in Sep 18, Unsalaried was 56% in Sep 18.
Salaried was 46.6% in Sep 19, Unsalaried was 53.4% in Sep 19.
Average Ticket Size was 14 Lacs Vs 8.3 Lacs for Gruh Finance and 27 Lac for HDFC
Yield on assets: 11.4% in Q2FY19 and 11.6% in Q2FY20
Cost of funds: 8.2% in Q2FY19 and 8.5% in Q2FY20
REPCO Home has a long operating history (established in year 2000). The cheap valuation looks enticing. Worth investigating more
The loan growth has significantly fallen from 51% in 2009 to12% in 2019.
The Gross NPA has increased from 1.2% to 3.0% but the key caveat is return on equity was stable at around 18%.
The key highlight of repco home finance is that it ends up recovering most of the NPAs through auction of properties. The loan write-off is very less for the company. It hovers around 0.2%.
The valuation performed by the speaker:
In the next 5 years, REPCO doubles its revenues i.e. growth of 15% CAGR. REPCO may not need to dilute any equity since its ROE is around 18%. REPCO is able to reduce NPA levels to historical average of around 2% (A big if)
Due to improvement in operating metrics, P/B ratio increases to 2.2 (not very unreasonable)
Geographic Concentration: 55% of loan book comes from Tamil Nadu. State level problems e.g. political turmoil, cyclone, drought, etc. may impact the business.
The current economic slowdown may impact asset quality further and its growth potential given that their customer segment may face income loss/fluctuation.
The overall market sentiment stays weak. P/B value of REPCO Home drops further in anticipation of worse times. This will severely test our patience and motivation.