This appears in the Deccan Chronicle of 9/10 = 10/10 .
(Investing in Bankings stocks, NBFC or Housing Finance company stocks is very popular. However, this sector is a minefield. )
The financial sector stocks have been on a tear since over a year. Whether it be NBFCs or Microfinance companies or private banks. They have grown their loan books much faster than the banking sector and also seem to have managed their credit evaluation far better.
The second one (managing credit better) should not be a surprise. A private entrepreneur lending to someone will logically undertake more due diligence in lending than a government official in a PSU Bank, where the employee has no stake. Bad debts are talked about and generally absorbed by the government exchequer after a hue and cry. This is unlikely to shift and hence private sector lenders ought to have a better asset quality than the PSU banks, as a general rule. Of course, there will be rogue private banks- where the ownership is diffused and no one seems to be in control (by and large, most of the older private banks will be under this category) and the bank becomes a handy tool for someone.
The first attribute, of higher growth, in Private lenders’ assets as opposed to the PSU Banks is also a natural thing. And given the paralysis in lending caused by regulatory noises in the PSU sector, the private sector growth rates are far higher.
The common issue with both the sectors is the absence of effective regulation. Yes, the RBI may have rules and regulations, but they are used at two stages- one, at the point of giving the license and the other is to write reminders when forms and returns are not submitted in time. Rarely do we come across any instance where the RBI has been able to diagnose trouble and warn investors or lenders about trouble.
In a bull market like this, price always runs ahead of fundamentals. Most will have sub twenty percent ROE but can trade upwards of four to five times book. Clearly, this is an expensive and high-risk buying proposition. The other interesting thing is that the more they grow, the more the capital requirement. Organic growth to reserves less the dividends they payout, may not often suffice to meet future growth needs. Thus, in every Bull Run, they have to keep raising resources, whether by fresh issuance of shares or by increasing the leverage.
In bullish markets, the finance companies also expand their loan book by huge lending to promoters and speculators. Generally, such lending is against shares and they take sufficient margins to protect themselves. Unless a finance company is lax in enforcing security, lending against shares is excellent business. Of course, the choice of shares holds the key to this business.
The most commonly used measure to value finance / banking stocks is the Price to Book Value. With growth and leverage, the book value should logically expand rapidly and it is for this anticipated action that the investor is willing to pay a high multiple today. One of the good ways to check is to examine how the book value has expanded, in the past. The Book Value, in simple terms is the total of capital plus reserves divided by the number of shares. In any finance business, book value expands in two ways- One by issue of new shares at a premium and two by the retained profits (PAT less dividends etc). I like to know how much of the book value expansion has come from accumulated profits and how much from share premium on new shares. A good finance business should have at least half of its increase in book value come about due to profit accumulation. That is a sign of a healthy finance business. Simply increasing the Book Value by issuing more and more shares, is not reflective of good business.
The other risk factor in owning stocks of finance businesses is the risk of frauds. This sector perhaps conceals the most frauds and deception. Sometimes, like in the case of Wells Fargo (an American bank with a great reputation and with a near ten percent stake held by the legend, Warren Buffett) trust can get eroded by frauds, which are not discovered immediately. Banking and finance companies have to constantly face this cycle of growth and problems. Just go back to share prices of the last twenty years and you will see boom and gloom in the prices of this sector. Yes, there could be some exception like Kotak or HDFC which generally boomed, but not all are in the same league. Tracking the ROEs will perhaps give a good indication.
Finance sector has a great following by the institutional investors because they believe that all growth is led by lending. Use that to advantage. Get in when the sector is out of favour and wait it out.