If the world had listened to Shakespeare and followed his advice, there would be no joy in the banking and finance sector. The world would have used money merely as a medium of exchange and there would be no borrowing, lending, NPAs, NCLT, IBC, non-standard accounts, delinquent accounts etc. Shakespeare even made a villain of a moneylender. Today, these villains are our heroes, at least in the stock market.
In any growth economy, the lubricant of growth is capital. Money takes different forms – debt, equity and various hybrid instruments. There is a whole range of services – insurance, third party money management, exchange of currency, speculation and what have you – which all revolve around money. For any economic activity to commence and sustain, money is the lubricant. It is but natural that the flow of money is the lead indicator for an economy.
However, to laymen as well as analysts used to navigating the financial statements of companies making goods or services, banking and finance companies often present a challenge with their truckloads of jargon and very different structuring of both the P&L and balance sheet. So let’s try to do away with all the jargon and drill down every lending business to its basics.
Finance is different
There are certain characteristics which make the financial business different from others which produce goods and services. Money cannot be lent to someone unless there is an inflow by way of capital or debt. Since it is not practical to lend only from capital, borrowing (or leverage) is the sustaining food for this business. Naturally in using this leverage, there are good and bad apples.
Governments across the world overregulate financial businesses more thoroughly than they do other businesses. Every aspect is regulated. How much capital a business should have (minimum), what businesses can be done, caps on individual/group loans, accounting standards, creating some ‘reserves’ and so on. Even key appointments and dividend payouts need approval and a ‘license’ is a must. The objective behind this is not very clear to me, though I suspect it is to ensure that there is no political or social crisis because someone played truant.
Does this mean that we investors too should apply different yardsticks to evaluating financial businesses? At a broad level, the ultimate test is ‘return on equity’. Normally I choose companies using this yardstick, since the purpose of any business is to make money for shareholders.
When it comes to the BFSI sector, I am not very conversant with the insurance business and its financial reports. So, my views are limited to lenders- Banks, NBFCs and Housing Finance Companies. I do not have a view on Holding Companies because I think it is counting the same apples twice and the value of a holding company is relevant only in a potential takeover.
Why lending is different
So, let me get down to the business of lending. In a nutshell, all of them use a mix of own capital and loans to lend to various borrowers. There is a direct cost payable for the borrowings that is measured and the cost of capital in a balance sheet is zero. The difference between the earnings on the money lent and the interest paid to the lenders (to the company) is the ‘gross’ profit available to a company.
From this, we deduct costs – people, technology, compliance etc and arrive at a number which is akin to Profits before Tax and amortisation for manufacturing companies. In a lending business, not every loan gets repaid in full or in time. There are some normal losses in origination. Sometimes the cost of following up will be higher than the profit on a loan. Sometimes, the borrowers are not able to pay. Sometimes it is a delay and sometimes it is a permanent loss. So, from the Profits Before Tax and amortisation, we need to write off the sums that are not going to come back. The balance left is what can be termed as ‘PBT’ in the conventional sense. Once we have this as our focus, it is very easy to assess a lender.
The CAMEL approach to evaluate banking and finance stocks
There are five main elements which can be used to evaluate the soundness and profitability of a lending business, whether it is a bank, NBFC or HFC. They are easily remembered through the acronym CAMEL.
C – Capital Adequacy
Regulators prescribe a minimum capital adequacy ratio for every kind of lending business. It is capital as a percentage of total risk assets or loans. This ratio sets a kind of cap on leverage. If Capital Adequacy Ratio (CAR) is set at a minimum of 12%, it means that the maximum leverage the lender can take in his core business is about eight times. This sets a limiting factor on growth. Higher the lender’s CAR, easier it is to grow with less dilution of capital. It is an irony that paying out dividends takes away capital that is needed to grow.
Lending is capital hungry. High rates of growth whilst maintaining a comfortable CAR, is not easy. It is rare to find a Sundaram Finance (has never ‘diluted’ capital since its IPO and one acquisition of a group company) or a Bajaj Finance, where dilutions have been minimal, thanks to high ROE which enables a high level of own funds generation. Indian banks have seen constant dilution of equity through fresh issuances.
A - Asset Quality
Capturing how much of the lending is to ‘good’ borrowers, this is the key to the profitability and indeed sustainability of any lending business. Companies like Sundaram Finance, HDFC Bank, HDFC Ltd, Kotak Bank etc stand out because of their high quality loan books, that call for very minimal provisions for NPA etc and enhance shareholder returns. PSU banks, on the other hand, constantly erode capital with their poor quality of loan book.
M - Management Quality
This is relevant for every business, but more so to the lending business. Trust is everything. Maintaining ethical standards on loan origination is key. Loans will not be repaid on schedule unless origination is honest. We have enough examples- Companies like HDFC , Sundaram, Bajaj, Kotak etc have been around for so long that we have a high degree of faith in their management. They do business ethically and profitably. We do not expect ‘surprises’ from them. This factor alone makes for a premium or discount to a financial stock’s valuation. PSU banks are a classic example where poor profitability is seen as a reflection of management quality and gets captured in poor relative valuations. The competence or ability of the management is bound to be reflected in the ROE over time.
Earnings for lenders arise from the ‘spread’ between lending and borrowing costs. The spread is usually decided by the quality of the loan book, which is decided by the sectors or segments that are the main borrowers. Retail lenders like Bajaj / Muthoot /Manappuram etc enjoy high rates of interest on their lending. This in turn gives the ability to cushion from more shocks. If loan repayments are prompt the pressure to dilute capital is lower. But higher loan yields can also reflect lending to riskier borrowers. Sometimes, risks can vary within the same sector. In a HFC, the quality of the loan book can be seen from the proportion of individual home loans to the higher risk bearing builder loans.
L – Liquidity
This is a critical aspect of any lending business. Money is a flow. There can be a timing mismatch between resources (borrowings) raised and lending. A lender has to constantly borrow more and more money to meet continuing repayments as well as meet new business needs. Getting money at a reasonable cost is key to profitability. The pandemic brought home the lessons on how liquidity mismatches can hurt lenders. Clients could not meet repayments in time and this in turn slowed loan growth. Regulators can sometimes interrupt repayments too, but obligations have to be met on time. This is why keeping unused lines of credit, liquid investments and the access to external funding support from the promoter group etc become important in the lending business.
Often the ability to raise resources from the capital market and the cost at which a lender can do it depends solely on reputation. That again tells us why both the business fundamentals and the market valuation of financial stocks ride on just one factor – the management.
Read the second part of this article here : Understanding valuations of banking and finance stocks