Financing business is simple but not easy, as often is quoted by many successful investors. The management that does not sway away and get influenced by the market forces but stick to their laid down principles of prudent lending, recovery and risk management processes will create long term sustainable shareholder wealth.
Lending can be largely divided based on the end purpose of the money as follows. The definition is NOT strictly applicable as many criss-cross lending is involved.
Income generation activities: Vehicle buying (trucks, tractors), machinery, working capital requirements. Example: Cholamandalam, Sundaram, banks, Shriram, Magma etc.
Consumption activities: Purchase of discretionary items like TV, Fridge etc, furniture, laptop, pest control (!), interior enhancements of existing office. Example: Bajaj Finance (though it also lends to income generation activities too), Capital first etc.
Asset creation: Best example is Housing finance. Here the asset is of emotional value too which explains the generally low levels of NPA compared to other types of lending companies. Example: Gruh finance, Canfin Homes, PNB Housing, Repco, Dewan, GIC, Indiabulls and a host of other brokerage NBFCs who have a housing finance companies.
Income generation at lower end of the pyramid: Micro-finance institutions. Typically the money is used for purchase of cattle, milk vending, micro enterprises, home businesses by ladies etc. The end users for this lending are impacted hard for any small change as they tend to have the lowest amount of discretionary money in hand and the scope of taking vagaries of business cycle and interference of outside influencers is minor.
Secular vs. Cyclical: The lending for consumption tends to be secular in nature while the lending for trucks tend to be cyclical as truck buying is directly related to the economic activity. So before investing in such a company, you need to be aware of the business cycles and which end of the cycle we are in and what valuations are the companies trading at. Of course, there are companies that tend to protect wealth much better than others during the downturn because of the prudent lending approach. The one who lent with careless attitude will get its equity wiped out during the cyclical lows.
The shareholder destruction is particularly harsh in lending companies because the raw material here is money! Business groups like HDFC, Kotak, Sundaram, Murugappa (Cholamandalam) tend to create sustainable wealth. HDFC, Kotak could even surmount the cyclical nature of lending business with their perfect balance of conservativeness vs. aggressiveness across business cycles. While the southern founded groups are ultra conservative with the best example being Sundaram finance. So, the wealth creation has been a little slower in these groups.
But the murugappas and sundarams survived world wars, financial crisis, Asian currency crisis of the 1980s and have a history of 100 years (Murugappa)! I personally believe with the advent of global education the next generation leaders at these business houses are more attuned to the shareholder wealth creation while keeping the values same. So, over the next decade, I expect these business groups to flourish.
It is extremely heartening to note that Sundaram finance did not raise equity for 40 years despite being a finance company where now a days even technology and asset light businesses go for QIPs left right and centre. While growth is very important, going sow in times of lower economic growth without mindlessly lending is more prudent approach. Immediate example of not raising equity for a decade is Gruh finance despite being a housing finance company.
Raising equity is not a great thing, in my opinion despite the argument that raising equity at high P/BV enhances shareholder value. Both Sundaram and Murugappas gave birth to super subsidiaries with their internal accruals rather than equity raising or huge debt while growing the standalone businesses. This shows the inherent strength of their business models. This gesture done over the last decade would come to fruition in the next economic up cycle is my personal belief.
Importance of Collateral:
The companies whose collateral rises in value with time or remains stagnant will typically have lower NPAs because of ‘economics’ from user’s perspective. Why would some one risk surrendering the collateral if the collateral’s value is greater than the outstanding loan? OR Why would some one risk losing an income generating collateral (like a truck)? As soon as a truck is confiscated, the owner tries all methods to repay the EMI and get back the truck and keep his business running!
Now imagine a loan has been given to fund a vacation, buy furniture for a new office, without a collateral. As long as the music is on EMIs will keep coming and at the first instance of trouble the EMIs for such loans will stop while at the same time the EMIs for his/her house, truck, machinery will keep going on! The consumers will prioritise the loan as per the ‘bread providing’ ability of the purpose of the loan. Quite logical, as you and me and everyone would do the same.
So, it is very important to note that GROWTH alone is NOT a sufficient parameter is investing in a lending company. It is the risk adjusted growth, collateral adjusted growth that is more important. Even if it is a housing loan if it is given without proper cashflow analysis to consumers to show cheetah fast loan book growth someday it will come back and bite you. So, the risk management practices comes into picture.
Anyway, coming to the company in discussion here, CHOLAMANDALAM is a company promoted by the Murugappa group.
Cholamandalam had its near death experience during 2009 when its partnership with DBS floundered big time. As per my reading at the advent of the economic top, Cholamandalam went on its lending spree for consumption,mostly to laptops. I believe, no evidence I have, that Chola would have depended on DBS for its business as DBS is a reputed group in Singapore. With the slack risk management practices, NPAs mounted and then Murugappas eventually took over the reigns by buying out DBS’ stake and appointing its own management and scripted magnificent turnaround. The valuations in terms of P/BV has grown almost 8 times plus the usual book value growth.
During the peak of its distress the group maintained high ethics, management morale, employees were largely shuffled to other group companies without any large scale employee firings. For me, the most important aspect of this turnaround was the discovery of Mr. VELLAYAN SUBBIAH an IIT alumnus.
Mr. Vellayan Subbiah brought the much needed consistency, predictability to the business which attracted large and reputed shareholders like CARTICA etc. He has left Chola now to manage the manufacturing business Tube Investments which is the holding company of Cholamandalam.
Cholamandalam is primarily engaged in the business of lending to below segments. Chola is very well geographically diversified and most of the lending is to rural and sub urban areas = socio economic class of B & C. They call it as the top of the bottom of the pyramid. The current AUM of the combined business is about 35000 crores.
Commercial vehicles (CVs) with market leadership in Light commercial vehicles. Construction equipments, tractors, cars, used CVs etc. This forms about 60% of the AUM. This 60% is further divided into: LCV:HCV:Others = 50:22:28.
Home equity (LAP) and Housing Loans: This should form the rest of the business. They started going slow on HE business at the start of 2016. They were one of the firsts to recognise the problem in this segment and have withdrawn ahead of the competition. While at the same time companies like Repco were accelerating. I believe this is what differentiates great managements from others. This is my personal observation, do not have statistics to prove my point.
From last quarter they have started accelerating the growth in this business but with focus on lower ticket size as banks were competing in the high LAP ticket size. I believe Bajaj Finance was the other company along with Chola which was ahead of the competition to recognise the pain and went slow.
Chola has recently tied up with HUDCO to increase focus on House Loans with clear focus on affordable housing segment. Over time, I believe this segment of lending will help it grow during the next cyclical downturn. In my opinion, Chola will have the best mix of cyclical and secular lending business few years down the line with risk adjusted growth and NPAs. Since the book is mostly of fixed lending in nature, the lower cost of funds and moving away from bank borrowings to market bonds will help it reduce the cost of funds.
Chola is also a very tech savvy while I believe the tech savviness was a bit delayed venture owing to its turnaround focus and the slowdown in its cyclical business form 2013. From 2013, its recovery costs were very high with gradual tapering off in times to come. All these should actually aid immensely in achieving RoA of 3% and RoE of 20% over 2-3 years. Thus a 20-25% grower with excellent management (the new CEO N. Srinivasan is a veteran of the Murugappa group who was also responsible for turning around the business and is incidentally the elder brother of Tata Group Chairman N. Chandrasekaran. What a family, I would say! Arun Alagappan (promoter) was appointed as an executive director. I believe eventually Mr. Arun will take over from N. Srinivasan after being groomed for the role for the next 2 years. It is this excellent philosophy of grooming the next generation leaders the hallmark of its longetivity. Mr. Arun was with Tube Investments if India earlier.
Chola has withered the demonetisation quite well compared to its peers. The results, the NPAs, the growth of the business is the testimony to this.
The company has withdrawn its payment bank license last year and I was very happy with this prudent decision which actually was the time when I started looking at the company. It may sound frivolous, but I was waiting if the company would go ahead or withdraw the payment bank license and I wanted to invest IF it withdraws.
Chola also has a securities subsidiary (brokerage) Cholamandalam Securities and wealth management subsidiary Chola distribution services engaged in distribution of mutual fund products, insurance etc., they are quite small in relation to its main business. However, I believe over the next decade they could grow into sizeable businesses with growth of the Indian economy. Let’s not attribute any value to this business anyway. Chola has also invested in a startup Whitedata systems which is a freight data aggregator on the line of Uber, Ola but not near to such scale at all. I’m not sure how this pan out either. Let’s not value this business too.
The story of economic growth of India over the next few years will play a major role. Even during the tough times, the business has maintained secular growth of more than 20% with excellent book quality (compared to its peers) even while moving towards 90 DPD NPS recognition as per RBI norms for NBFCs.
I assume, sometime in future at an appropriate stage Chola might apply for a banking license. This is all pure conjecture and should not hold the thesis for investing at the current juncture.
I will not go into the valuations analysis and numbers in my post as this is largely subjective. While valuations at the entry point are very important, equally important are the opportunity size and how management is placed to effectively exploit this, risk adjusted growth, management quality, consistency and predictability of the earnings.
The company is quite discovered as mutual funds and FIIs hold large stakes in it and is quite actively researched by brokerage houses.
Latest investor presentation: http://www.cholamandalam.com/files/Investor%20Presentation/Investor-Presentation-Jun-17.pdf
Latest annual report: http://www.cholamandalam.com/files/MEDIA/Annual-Report-2016-2017.pdf
Getting future ready is the theme of the latest annual report, which I agree to as well.
Disclosure: I hold shares in the company from the past and have bought or sold in the last 30 days. I change my opinion quite swiftly based on change of facts. I’m not SEBI registered analyst and this is not a recommendation but purely a discussion for educational purposes.