(This appears in today’s edition/s of Deccan Chronicle. The finance companies- whether NBFC or HFC sector- became expensive- then ILFS attack happened. Now fear- An opportunity … Be selective, slow and patient…
The Financial Sector- An opportunity
The finance sector stocks are in turmoil. Wave after wave of negative news-flow that takes prices lower and lower. Credibility of companies being questioned. People saying this is a good time to buy. Some saying “I told you so”.
It is good to see this sector getting some attention. The investment thesis in this sector is driven by an assumption that all growth is driven by money and hence the providers of money are natural winners. The seemingly endless growth rate justifies exaggerated valuations. All valuations are defended. A high valuation of one stock is used to justify higher valuation for their poorer cousins.
The core business is money lending. Prudent lending is backed by solid income streams and sometimes hard assets. Hard assets that can be realized for value to settle loans when the income does not flow as anticipated. Thus, the analyses of cash flow or income is the most important thing for a money lender.
“Collateral” or “Security” is often just a word. Any asset that has value in a public and easy sale is probably the only real ‘security’. A machine that is worth a crore may be worth just its scrap value in liquidation. A piece of land is based on valuation. Unless you know the land and the market, the security is useless. A bank putting a number to acres of some industrial estate is probably just filling in the columns.
The money lender of the text book uses his core capital to lend. He does not borrow in turn and lend. He does not seek growth beyond what he has. However, the limited company structure, the lure of stock valuations make the NBFCs to borrow money and lend. They want to use as much of this ‘leverage’ as possible. Their small equity based can then enjoy the profits made on the borrowed money plus the returns on own money. This is the universal model.
One important assumption in ‘keeping well’ for these businesses is that repayments will be on schedule and borrowing pipelines do not get choked. They are emboldened to borrow near term money and keep rolling it over. Commercial Paper is one such tool. Unfortunately, the buyers of Commercial Paper are mutual funds and insurance companies. Even Banks invest short term money in Mutual Funds which invest in Commercial Paper. Thus, bank credit flows to these NBFCs through a ‘makeover’ facilitated by the mutual funds. And while the bank may charge the NBFC a rate of, say, 12% for direct lending, the CP route may fetch money for the NBFC at a rate of 8% or so!. And the Bank that invests in mutual funds may get a return of six to seven percent on its investments.
The Bank money in Mutual funds works to lower the rate of interest available to the bank on its investible monies. As the money supply grows, other investment pools come in the NBFC business seeking fixed returns. A whole eco-system is created which results in NBFCs getting more money than can be handled prudently. All this is heading towards exotic lending like automated lending, lending driven by “Artificial Intelligence”. As lenders find more and more easy money, the time spent on risk management comes down. The market wants rapid growth. Quarter on quarter. Year on year. And one day, one or both of the things happen- The borrowers do not repay in time or some loans go bad. Many times, the cost of chasing a loan recovery is large. When automated systems drive instant loans, recoveries are zero. The lender backs on probability of default and prices it in. Alas, human behaviour is never a smooth predictable curve. Surprises are always round the corner.
Similarly, a crisis of confidence like the present one has resulted in the choking up of money flow in to the lenders. This means their growth plans get hit. And it also has a negative impact on ‘roll-over’ loans, where the health of the loan was kept in the green by new loans to replace the old. Maybe the finance companies will not take a big hit to their bodies, but surely, the growth numbers, the cost of money and the ROEs are slated to come down. They will come down till the next round of crazy money comes their way.
This is a cycle. The financial sector will go from fear to greed and back. There is no need for any advance warning. I do not have any clear financial indicator that will give us or tell us about turning points. As investors in this sector, it is best to stick to established names. They may not give you exponential returns. When the sector falls out of favour, everyone will fall. The good may fall less than the bad, but fall they will. Use this opportunity to build up a High Quality portfolio in the finance sector. Look for stocks of companies where promoter reputation is good, history of doing well over ten years plus and strong management teams are in place. In finance business, history and trust are important attributes. It is not difficult to establish these factors. I must caution that I am NOT calling a bottom on this sector yet.