There are two types of companies according to the profits they make.1st type of companies which can make profits and have the ability to transfer that cash to the shareholders.2nd type of companies which make profits but can’t transfer all the cash to the shareholders.Its not like that, they can invest the cash and make more money for shareholders,but it’s the nature of business which does not allow the 2nd type of companies to throw cash to the shareholders.Yes I am talking about banking and NBFC businesses.What is a perfect business? A perfect compounding machine is that which invests back it’s profits to the business and makes more profit.First understand the lending business.The bank takes the raw material i.e. deposits from people and lend that money to people as loan and difference between deposit interest and loan interest is the profit for the bank.The bank may make Rs.10,000 crore profit in a year,but can’t share Rs.8,000 crores of profit to shareholders as dividend because it is having huge liability as deposits.So the profits of the banks are illusionary i.e. which you can see but can’t feel.Then how the shareholders will make money? The only way the shareholders will make huge money in a lending business is ,only by the appreciation in the stock price.The only way the stock price will go multi-fold is, if it’s earnings grows in handsome rate.So,there are two things you need to understand that ,1st the bank should be in its initial phase where the base profit is very low ,so that profits can mathematically rise in high % rate.2nd thing is ,the market cap should be of very low base,so that sufficient room is available in the market cap so that it can go up multi-fold. In other words its current stock price should not be discounting it’s potential future market cap.
The risk is that, what if market decides that from now onwards ,it will not give 30 PE multiple to a lending business…since the lending businesses do not have the ability to pay high dividends to the shareholders and decides to give 10 PE to such businesses.So in this scenario if u have bought the stock in the initial phase of the business ,then after 15 years, the earnings would have multi-fold and even if market gives low PE multiple ,still your can make multi-fold profit.
The perfect scenario for a bank to make super normal profit for its shareholders is that, when it becomes big enough and making Rs.40,000/- crores of yearly profit,then it should use this cash flow to decrease it’s deposit liability by Rs.40,000/- crore.But technically it is not possible.What HDFC Bank would tell to it’s depositors ? Is it going to tell it’s depositors to take back their money or reduce interest rates drastically.In both the cases the risk is that it’s deposits can collapse at instant.Another risk is that it can loose customer relationship and customers may not come for taking loans from the bank.So,the bank need to play the game 365 days irrespective of potential availability loan demand by quality customer.Because if it do not find sufficient good customers,then it’s margin will hurt,as it has to pay the interest to the depositors.So the bank need to keep hunting for customers.I just don’t like when companies hunt for growth.It just make them impatient and they tend to focus on outer score card rather than inner score card.When companies hunt for growth ,they are more obsessed with top line.They focus more on results rather than processes.But what I think, it is the process ,which creates result.So ,I am afraid of companies who are in hunt for growth.I like businesses ,where organic growth is there and hunting is not required.
So, for avoiding above risks,If I want to invest in a lending business,then I need the following margin of safety.
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Organic growth opportunity should be there
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The lending business should be growing i.e. the management should have the hunger for growth, but not hunting for growth.
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The lending business should be at it’s initial phase and at low market cap as well i.e. its current stock price should not be discounting it’s potential future market cap.
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The company should be more concerned with processes ,rather than sales volume.