FINANCIALISATION: TSUNAMI expected in AMC & Insurance?


(Donald Francis) #1

Of late, I am a big convert to practical distilled wisdom from Bharat Shah. it’s best to simply reproduce how he explains why Banks and Financial businesses occupy a special place within high growth compounding machine space.

Within high growth and compounding machine space, banks and finance occupy a special place. Given the ubiquitous need for and lubricating presence of money, and also given the real large size of opportunity, successful finance businesses can get to be very large. Observe the pole position that finance sector occupies in a large and tertiary sector economy such as USA, not just before the cataclysmic events of 2008 but even thereafter.

Bank and finance businesses represent a very unique opportunity in several respects.
1. They are inherently a compounding machine, especially in a continued phase of high growth of the economy since they represent a proxy on the growth of the economy
2. Typically, these businesses tend to be a lead indicator of the growth rather than a lag, in the sense that typically the growth of the banks and finance firms precedes the GDP growth i.e. the growth of the sector tends to be a multiple of the growth of the GDP

In terms of the character of business, there are other distinguishing aspects as well, compared to most other businesses.
1. There is no concept of return on capital employed for obvious reasons
2. It is legitimate for these businesses to have a significant leverage as compared to other businesses such as manufacturing
3. Dilution of capital is part of the game and is not a ‘crime’ as it would be regarded in the other businesses simply because the raw material is money and to that extent the size of the growth will call for well-timed and efficiently priced dilution at defined intervals.
4. RoE is not just an outcome of the earnings growth, but a cause as well

The key value creating parameters are, typically, a matrix of the quantum of growth and quality of the growth (i.e. return on equity). the RoE would be a function of how good is the return earned on assets, how well is the balance sheet quality maintained i.e. deinquency is contained (balance sheet is even more critical than profit statement in judging the health of these businesses), how efficiently have the expenses been managed and finally what has been the level and appropriateness of leverage. Return on Assets (RoA), in turn, is a function of efficiency of the asset book, cost of liabilities, duration management and asset-liability mismatch

The aspects would percolate from a given level of RoA to a RoE. So the critical part of the quality is the RoE which subsumes within itself all four of the above parameters. The growth again is an outcome of a superior RoE, the size of opportunity in the external space and ability of the management to harness the environment, to appropriately take advantage of this opportunity by strategic and well-timed dilution of capital. Thus broadly the matrix would be that the superior RoE combined with superiority of earnings growth will provide the most potent combination and clearly a mediocrity of the RoE would have the most telling effect on the size and the extent of value creation, as well as the size of growth.

When we try to apply this practically to current markets, a few opportunities immediately would call attention. Thought it relevant and topical to start a discussion now on the special compounding machine thesis, and obviously draw attention to value-price mismatched winners.

Hope to see folks giving this some attention:)
Cheers


How to find a Compounding Machine
#2

This is very true.

HDFC Bank is in sweet spot. With impeccable asset quality, garnering more than 50% of card market, majority of car loan market and consistent growth. It will not be surprising that this may continue to grow at good pace for a decade.

HDFC - Growth has slowed a bit due to sluggish reality market but is likely to bounce back sooner than later. Good insurance subsidiaries. Trying to create a niche in education loan thru Credia. This is going to be huge going by developed country trends.

Cholamadlam - Has navigated commercial vehicle market in far better manner than Shriram Transport Finance. Shows in results. Has been up 2.5 times in 2 years where STF is at same level.

AB Nuvo - Extremely cheap. Consolidated PE < 6 at CMP. Good play on insurance and MF. MF is reaching a tipping point beyond which it will grow exponentially.

Gruh: Good play on loan in non-salaried. But PE/PB is much higher than HDFC bank. For a 20% grower HDFC bank is preferable.

Repco: Good growth. NPA is a concern. Even larger concern is that it is a government company at end of the day run by babus.

Disclaimer: First four are my core holdings


(Prash) #3

Very nicely written. I have been trying to understand the banking. It looks easy sometimes easy on paper to understand, but can become very complicated based on how it is run and who runs it.
A recent quote from Charlie Munger on decision to buy Wells Fargo

On the Wells Fargo buys: “When Berkshire bought Wells Fargo, the world was unglued in real estate lending-driven banking panic. We knew their bank lending officers weren’t ordinary. They grew up in the garment district as cynics and were careful and better [than others]. This was an information advantage that we had that Wells Fargo had this special capacity. When DJCO bought into Wells Fargo at $8, we knew the bankers were more rational than ordinary bankers. No one should buy a bank without a feeling for how shrewd management is. It is easy to delude yourself into thinking things,as it is very easy to hide"


(Tirath Muchhala) #4

Fantastic stuff Donald. Where is this from?
There is a reason why certain NBFCs are becoming stronger in India - they are more free to provide capital to sectors that banks dont want to or cant go. The recent disclosures about the size of Berkshire’s Clayton homes is a case in point. USD 12 B + portfolio on its books.
The reason you mention is what Buffett has seen for a really long time now.
The trouble of course is, how do you understand the value of HDFC Bank at 30 PE or so 10 years or 15 years ago?
That said, I wonder if there is a special place for Indian NBFCs in providing capital to real estate, SMEs, etc.


(tejasjamin) #5

Hi Donald,

I appreciate you have started this thread. I also feel banking is great opportunity to make money at this point of time.One stock I am closely following is IDFC Bank. With 40 book value, low NPA & high capital adequacy ratio of 20, stock looks promising. pls share your views. Thanks Tejas Amin


(varun jain) #6

It will take 3-4 yrs minimum if all goes right for return ratios to normalize and inch towards respectable figures comparable to banks like Axis, Indusind etc.


(Donald Francis) #7

Hi Tejas,

If you read the above carefully, the accent is on superior ROA/RoE combined with superiority of earnings growth.

IDFC Bank with RoA/ROE somewhere around 1.2%/7.2% has miles to go. It needs to prove itself before it can belong to above club. Though, you can always make a case for valuation mismatch - based on where it is today. An Opportunistic bet need not translate into a special compounding bet - which is aimed as the subject of this discussion.


(amit) #8

it is very interesting sector. I have been trying research on the subject of valuation and what successful Financial services companies do. One thing is certain that banks with good lending history create for themselves a positive feedback cycle . Less NPAs , means less provisions , means better ROA and hence bank is under less pressure to expand lowering it is lending Quality.

HDFC Bank is example which is very unique across the world. It is richly valued and big and hence you feel hesitant .But even Warren buffet says that in Banking you should pay for Quality of Management . Plus these large banks will not need much equity dilution as they become large and Non Interest income rise.

though he bought Bank of America as he got very sweet deal during the crisis. His 5 Billion investment is already 11 Billion now plus 9 % interest which gets .

Another thing which i learned that Banking becomes concentrated so eventually consolidation happens.

I have large portion of my portfolio in Banks and NBFCs.

I bought J&K , South Indian bank , Bajaj Finace & Indus Ind Bank

Trying to find more material on understanding this sector but it is really difficult as banks can hide problems and you may not get access to information.


(Girish) #9

Donald,
I have read one splendid book called "The Davis Dynasty: Fifty Years of Successful Investing on Wall Street
by John Rothchild. You may enjoy this book. Shelby Davis built his fortune investing for 40 years in insurance companies that he understood deeply. His son also invested mostly in finance companies- banks, insurance companies etc. And now his grandson is doing the same successfully. Basically same formula…investing in good quality businesses at cheap price and then hold.

Their web site has pdf that articulates their selection criteria and how they calculate FCF (they call owner’s return).


(v4value) #10

Thanks Girish. Can you post the link to that article? I wasn’t able to locate…


(Prash) #11

I am trying to find some correlations on what metrics/ratios really play on the banking valuation. Among all I found the ROA/ROE is finally what reflects on the PE valuation.

A simple table as below shows,

So can we say, a good bank should have best ROA?

PS: ICICI bank I have excluded as somehow the data I got for the Bank from my screener wasn’t clear.


(Srinivasan Sundaram) #12

Might be this…

From http://davisfunds.com/

At Davis Advisors, we seek to purchase durable, well-managed businesses at value prices and hold them for the long term to allow the power of compounding to work.

The Davis Investment Discipline begins with the premise that stocks represent long-term economic interests in real businesses. With that in mind, our research process begins with two essential questions:

What kind of businesses do we want to own?
How much should we pay for them?
Identifying the Types of Businesses We Want to Own

To answer this question, we try to determine if the businesses possess characteristics that foster creation of value over long periods of time. These characteristics include:

Proven management.
Durable, financially strong business models.
Sustainable competitive advantages.
To learn more, see What We Look For In A Company.

Determining the Price We Should Pay

Once we have identified businesses we want to own, we wait patiently for opportunities to purchase shares at a discount to our estimate of their intrinsic worth. We believe this provides a margin of safety that can enhance our potential return while mitigating risk. Components of our proprietary valuation methodology include:

Calculate Owner Earnings rather than taking GAAP earnings at face value.
Determine a company’s true Enterprise Value.
Calculate the Owner Earnings Yield.
Compare the Owner Earnings Yield to the risk-free rate.
How Much Should We Pay?

Our goal is to purchase durable, well-managed businesses when they are trading at a discount to our estimate of intrinsic value in order to establish a margin of safety, which can enhance prospective returns while reducing investment risk.

To determine how much we should pay for a business, our investment process considers four factors: Owner Earnings, Enterprise Value, Owner Earnings Yield, and Reinvestment Rates.

Owner Earnings

Owner Earnings are the excess cash a business generates after reinvesting enough to maintain current capacity and competitive advantages but before investing for growth.
To calculate Owner Earnings, we pore over income statements and make extensive adjustments.
We pay close attention to extraordinary items, differences between maintenance capital spending and depreciation, the cost of stock options, and pension assumptions, among other items.
We also consider where a business may be over-earning or under-earning versus its potential over full market cycles and try to normalize line items where appropriate.
Enterprise Value

After determining Owner Earnings, we compare that figure to the price we would realistically have to pay to own the business, which we refer to as Enterprise Value.
Enterprise Value takes into account equity, debt and off-balance-sheet liabilities as well as certain technical balance sheet adjustments and represents the price we would have to pay to purchase the entire business and own it free and clear.
Owner Earnings Yield

By comparing Owner Earnings to enterprise value we can value a business on a multiple-of-earnings basis or, inversely, on an earnings-yield basis where we divide Owner Earnings by Enterprise Value and calculate the going-in yield – i.e., the initial return we would earn if we purchased that business in its entirety at today’s prices.
The Owner Earnings Yield is a standardized method by which we may judge the attractiveness of a business relative not only to the prevailing risk-free rate (e.g., the interest rate on short-term U.S. Treasury bills) but also relative to the earnings yield offered by other potential investments in the market.
Reinvestment Rates

Finally, we consider a range of growth rate assumptions that are partly based on organic growth and partly based on assumptions about future returns on capital.

http://davisfunds.com/downloads/DARschMeth.pdf


#13

If yu follow this methodology, one can never buy stocks in Indian scenario. Just calculate Yield for Persistent and PIINds which are at a very attractive valuations now . With this methodology one can buy stocks when there is a crash or a bear market scenario. In that case, we dont need any method to pick up stocks.


(Binu) #14

Hello Prash, good attempt to find the strong co-relations.

Trying to use that co-relation to the valuations, according to this relationship Indus Ind bank should be should have been given the highest valuation followed by CUB followed by Kotak Bank and then by DCB before HDFC bank. However, that doesn’t seem to be the market’s trend of assigning valuations.

~binu


(Girish) #15

Yes. This is the one.

I also recommend the book which is written by excellent writer. The book is a delight to read because of his writing skills.


(Girish) #16

In my experience P/B is better metric than PE for finance companies. Because much of their book value is cash which is not depreciated (OK, ignore inflation for a moment).
ROE is a gauge of profitability and quality of earnings. High ROE allows you to grow without equity dilution.
GNPA and NNPA are gauges of earning quality and lending standards.


(Girish) #17

@sethufan: Did not understand your comment. Why do you think it is impossible? Only in the last stage of the bull market it becomes difficult to buy. Otherwise even good companies correct substantially when they miss quarterly earnings guidance from time to time. They get hammered in that case. If the problems are temporary then you pounce upon the opportunity when the valuation becomes attractive again. Your analysis should help you make that judgement.


(Srinivasan Sundaram) #18

I don’t have finance background… Mostly learning thru posts in Valuepickr and books suggested in the forum. reproducing " Shiller PE " from today’s economic times

Why Shiller PE is a better measure of valuation of stocks
By Narendra Nathan, ET Bureau|Mar 21, 2016, 08.00 A …

Read more at:


(Prash) #19

Hi Binu,
If you see the IndusInd Bank and Kotak are indeed at high valuation 33+ PE b’cos they have very good ROA. They may continue at this valuation as long they maintain superior ROA.
At the same time HDFC is also trading at 23+ for its size, which is quie high, but justified again because of good ROA and also management and consistent history.
Now taking this correlation, if any bank has good ROA, but has a low PE (CUB, DCB) means, there are 2 ways to see,

  1. The stock is at a discount and market has still not discovered the company and good to buy
  2. There are other factors which are holding the company valuations other than ROA or even ROA is not consistent.

Overall, I am interested to know, can we infer from correlation that for a bank PE to get re-rating it should show good ROA over a longer term. The other way to infer is avoid entering the bank stock which has low ROA

P/B is more of again, says if the company is trading below book value or not. But it doesn’t say why trading at less P/B. If ROA is going down, it is for sure it will be lower or will go lower.


#20

If you calculate the yield as per his method and compare with our risk free rate, one will hardly find any companies to invest. For example, Persistent even at its low in recent months just giving an yield around 2%. Same is the case with PIINds @ the recent low of Rs 595/-. As per his calculation, since both are below 8% ( our risk free rate), just not fit for investments. Whereas the analysis of 2 companies give a different story. This is the method to start with for the first year as per his method.

Just find one good investment in India which would fit as per his calculation.