The Indian Financial Services sector provides long term investors an opportunity to benefit from three tailwinds which are unique to India: (i) the Financial Services sector grows at a multiplier of real GDP growth. In addition to being one of the faster growing economies in the world, India’s banking sector credit growth since the global financial crisis (FY09-FY20), has been 2x of real GDP growth on a median basis, (ii) public sector enterprises still dominate the Indian Financial Services sector and continue to lose market share to private players. As a result, in addition to banking sector credit growth being 2x of real GDP growth, private banks in India have grown at 1.75x of the banking sector credit growth since FY09, and (iii) wide dispersion in the quality of companies within the private Financial Services universe provides an opportunity to a select few well capitalized private players to accelerate market share gains post a crisis. The Kings of Capital portfolio is a concentrated portfolio consisting of private sector Financial Services companies which are well positioned to benefit from these three tailwinds.

Performance update of the live fund

The key objective of our “Kings of Capital” strategy is to own a portfolio of 10 to 14 high quality financial companies (banks, NBFCs, life insurers, general insurers, asset managers, brokers) that have good corporate governance, prudent capital allocation skills and high barriers to entry. By owning these high-quality financial companies, we intend to benefit from the consolidation in the lending sector and the financialization of household savings over the next decade. The latest performance of our PMS is shown in the chart below.

As a select few lenders such as HDFC Bank, Kotak Bank or Bajaj Finance have consistently grown at a healthy rate over the past decade despite a tough macro environment, we have received questions around whether this growth come at the cost of taking higher risks and whether these companies will continue to grow at a healthy pace in the future or have they become too large to grow earnings at a healthy rate. We try and answer these questions in this newsletter.

There are three layers of growth which a well-managed private Financial Services company can benefit from.

First layer of growth: the Indian banking sector grows at ~2x of real GDP growth

As India is still a developing economy with low credit penetration, not only does India’s GDP grow at a relatively healthy rate but credit growth is also a 2x multiplier of real GDP growth. In the three years prior to the global financial crisis, India’s real GDP was growing at ~8% while the Indian banking sector’s credit growth was 33%, 32% and 31% in FY05, FY06 and FY07 respectively. It is widely believed that when an economy’s banking sector credit consistently expands at more than 3 times the real GDP growth, it eventually leads to rising NPAs at a systemic level. This heady growth of over 30% was followed by the global financial crisis and rising NPAs for the Indian banking sector. However, since the global financial crisis (GFC), banking sector credit growth has been more subdued at ~2x of India’s real GDP growth. The post GFC period can be divided into two distinct phases:

  • Phase 1 (2009 to 2014): During this period, the public sector banks continued to grow at 15-20% and the funding of long-term infrastructure projects, greenfield projects, giving loans to dodgy corporates continued. As a result, the credit growth was broad based across private and public sector banks during this period.
  • Phase 2 (2014 onwards): During 2014-15 as a part of RBI’s asset quality review most public sector banks and a few private sector banks were forced to recognize additional NPAs. The recognition of these additional NPAs had a severe impact on the networth of these banks. As most PSU banks saw their Tier-1 capital being eroded, their ability to lend reduced considerably. As the capital starved PSU banks still had 70% market share in India’s banking sector, the country’s credit growth decelerated to 8-10% during FY15-20. What made the situation worse was that the RBI’s asset quality review was followed by multiple other macro headwinds over the next few years such as demonetization, introduction of GST, the ILFS crisis, the DHFL crisis and the Yes Bank crisis. However, as we will see in the next section even during this period the private sector banks continued to grow their loan books at over 15%.

Second layer of growth: Private sector banks grow at ~1.75x of banking sector credit growth

All PSU players have an inherent conflict on whether they should allocate capital to reward minority investors or work to achieve the social or political objectives of their majority shareholder (click here to read our 19th Feb, 2020 blog on why PSU stocks disprove the efficient market hypothesis). This dynamic of PSU players losing market share is therefore structural in nature and holds true for the general and life insurance sectors as well.

While the credit growth of PSU banks was significantly impacted post 2014, private sector banks have been able to grow at 15%-20% despite the Indian Financial Services sector facing multiple macro headwinds over the past few years. Most of the growth for private players during this period has come through market share gains from the PSU banks. During FY14 to FY20, private banks increased their market share from 24% to 40% of loans outstanding. This unique dynamic of market share gains is the additional multiplier on top of the GDP multiplier which works in favour of private sector banks.

Third layer of growth: A select few players are able to benefit from this unique opportunity in India’s Financial Services sector and grow profits consistently

Despite the unique opportunity provided by India’s rapidly growing private financial services sector, only a handful of lenders have been able to grow profits consistently. The ability to grow profits consistently for any company is dependent on:

  • Reinvestment rate: Unlike some of the western countries where there are no avenues of reinvesting profits, as discussed in the earlier section, the Indian Financial Services sector is growing rapidly and provides a long runway for growth. This results in Indian lenders having a high reinvestment rate. As seen in Exhibit 4 below, the likes of HDFC Bank, Kotak Bank and Bajaj Finance consistently reinvest over 80% of their earnings back into the business. Despite the reinvestment rate of these high quality lenders being in excess of 80% for more than a decade, none of them have reached a market share of even 10% yet in India’s lending industry. Bajaj Finance for instance has a market share of less than 1.5%.
  • Raise leverage upon the reinvested capital: Not only do lenders reinvest more than 80% of their earnings back into the business, but the reinvested capital is further used to raise debt which is also deployed in the business. This amplifies the impact of a lender’s reinvestment rate. To understand this better, consider the below illustration which highlights the differences between a bank or NBFC and a debt free non-financial company. The illustration highlights that for a bank or NBFC which is leveraged 8x, an 80% reinvestment rate implies a reinvestment rate of 720%.

  • Generating consistent return on assets: The ability of lenders to reinvest 8 to 9 times more capital than a conventional company works wonders for those lenders who are consistently able to generate sustainable return on assets (RoA) while it destroys lenders which are unable to consistently generate return on assets. Given that any rapidly growing sector attracts competition either from new entrants or by way of aggressive pricing from existing players, India’s lending sector has been no different. India has thousands of NBFCs and a long list of banks. However, only a select few players such as HDFC Bank, Kotak Bank and Bajaj Finance have been able to build competitive advantages to generate consistent RoAs leading to rapid profit growth. (Click here to read on Kotak Bank and here on HDFC Bank’s competitive advantages)

Investment implications

While there are sectors other than Financial Services which have historically delivered strong growth, such strong growth in other sectors has been either cyclical (eg. infrastructure) or the benefits of strong growth have been passed on to the end consumer (eg. airlines, real estate and telecom) as the companies in those sectors have been unable to create any competitive advantages. What makes the Indian Financial Services sector unique is the consistent growth for private sector players and the ability of a select few players to generate return on equity above cost of equity.

Given the favourable sector dynamics and the fragmented nature of the industry, investors do not need to chase growth by investing in low quality lenders as growth expectations of investors will be taken care by strong sectoral growth itself. The Kings of Capital portfolio instead focuses on downside protection by investing in companies which have clean accounting (click here to read our newsletter on how to spot naughty lenders), adequate capital buffers (KCP lenders have a Tier-1 capital of 21% on a median basis, nearly 2x that of other lenders) and the ability to generate return on equity above cost of equity because of their competitive advantages. Such a concentrated portfolio of high-quality private sector financial companies is well positioned to absorb downside risk and capture the unique upside opportunity that the Indian financial sector provides.

Note: HDFC Bank, Kotak Mahindra Bank and Bajaj Finance are a part of many Marcellus portfolios.
Regards
Team Marcellus