Indian NBFCs : Shadow banks may hit a bump on frothy valuations.
Every bull market needs a hot theme that can fuel fervor and frenzy among investors. Usually that crown is reserved for an emerging sector that is long on promises, but short on specifics. Internet boom in 2000 was one such classical case. But, this time, bucking the trend, market has latched on to one of the most unlikely sectors for its steroid. It is not a sexy emerging business. It is an age-old dull business that has been around since the time private businesses took roots. Lending is no fancy business, but, by taking NBFCs and other retail financing co’s to lofty levels of valuations, Indian market hasn’t disappointed its ardent followers by showing how insanely irrational it can stoop to.
Like every hot trend, it starts with certain fundamental triggers, but soon gets hijacked by hyper momentum. It is no different in this case. To begin with, the prospects for NBFCs and retail lending brightened with key fundamental triggers such as,
Increased credit demand on falling interest rates
Improved profit outlook for lending on lower cost of funding
Significant market share gains for NBFCs (including HFCs (Housing Fin Cos)) at the cost of large banks such as ICICI, Axis and SBI that are saddled with stressed assets.
Increased liquidity to NBFCs/HFCs from alternate source of funding (besides banks) to tap into this growing opportunity.
Increased demand outlook for HFCs from rural and semi-urban.
Surging demand for microfinance post stability in regulatory norms.
While these factors in isolation may look not very unusual, the combinations coming together conspired a deadly revival in the earnings momentum for this sector. That set the bull case for the sector. Once in control of bulls, soon, momentum morphed into mania leading to froth in valuation in much of the stocks in the sector. Stocks such as Bajaj Fin, Canfin homes, Gruh Finance , Equitas and Ujjivan have surged and are quoting at unsustainable price-to-book valuations. Valuation multiple for most of these companies are much higher than established and well run larger players like HDFC and HDFC Bank. Take for example, Bajaj Fin is at over 8 times the price to book (FY16) while the multiple for HDFC Bank is less than 4.5. Gruh Fin is at the fanciest level at over 14 times P/B multiple.
Such froth in this sector is scary for the simple reason that the business model of lending is murky at its core. It is a business where profits are front-loaded and losses are back-ended and thus making the business fundamentally risky. Loans are easy to give and so are profits in the beginning. But when loans sour later ( as in most cases), write-offs come back to hit in a back-loaded fashion. This is not to say that this business can’t be run conservatively. But the inherent risks in the lending business make it an average business at best or a fragile one at worse. Valuing such businesses at stupendous multiples like the ones in the current market is fraught with ruinous risks which the investor can ill afford. Froth in this space gives an excellent window for investors to exit positions clinically. While it could impact the returns in the short-term given the daily surge in stock prices in this space, it will prove to be a prudent one in the long-term with these stocks set for major regression in the eventual correction.
Happy Value Investing!
(From a blog)