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Searching for Compounding Machines Among Financials in India

By Soumil Zaveri, a featured instructor at Asian Investing Summit 2017

Indian banks and financials have always been heavyweights in our family office holdings. Our keen interest toward them is driven by the confluence of a few very favorable factors, which are highlighted in this note, juxtaposed with a little bit of background and storytelling.

Diligent financial management teams and owner-operators have built exceptional long-term track records driven by resilient underwriting standards, cost leadership and customer centricity in an environment where private lenders (as opposed to government promoted and controlled entities) were allowed to start formal banking operations only as recently as 1994 (excluding a few very small, regional "old private sector" banks and non-banking financials companies (NBFCs) which operated with several limitations).

In this regard the public sector lenders had more than a four decade-long head-start in post-independent India. Although their combined market shares have consistently eroded they remain the largest financiers in terms of lending (~71%) and deposits (~74%). The majority of them have often been stymied by weak branch-level governance, poor operating performance, sub-optimal underwriting capabilities, insufficient technological infrastructure, poor alignment of interest and a reputation for inadequate customer service. These issues have manifest themselves in their "share of market capitalization" among listed banks and NBFCs, which has consistently declined and now hovers below 30%.

Public sector banks have been able to retain such market shares because their largest equity holder is less demanding of purely financial outcomes. Rather, these banks are viewed as a platform to improve the breadth and depth of banking penetration in the country -- especially in less affluent villages where full service branches may not make economic sense purely from a financial perspective. While this approach has been successful in creating an extensive branch network across the country it has come with higher operating expenses and weaker underwriting standards. This has led to the unsurprising outcome that despite their >70% market-share their share of stressed assets stands at 90%. Their weaker balance sheets have hampered their ability to extend credit to grow their loan books and raise meaningful capital.

Despite these institutions' social responsibility-based approach, India continues to be credit hungry. Household debt, mortgages and consumer financing as a percent of GDP are at fractional levels of not just developed economies but even several developing ones. All this in an environment which is known for a low base level of consumption, high housing shortfall combined with increasing disposable incomes and affordability.

This slack in the public sector banking system combined with a growing middle-class has allowed for performance-oriented private lenders (banks and NBFCs) to reap rich rewards -- for example, HDFC Bank (incorporated in 1994 and now the largest private lender in India) has grown earnings at ~37% CAGR from INR 0.2 billion in 1996 to INR 122.96 billion in twenty years. Kotak Mahindra Bank (converted to a bank in 2003 and now the 4th-largest private lender) has grown earnings at ~35% CAGR. Both companies have rewarded investors commensurately over any reasonable timeframe along the way.

Despite several years of continued compounding, even today HDFC Bank's market share is ~5% (Kotak Mahindra Bank is less than 2%). Given the market share gains that are to be had from the large, less efficient, capital-constrained public sector and the overall growth in the addressable market for consumer and small business lending, we believe businesses like these continue to possess extraordinarily long runways for growth from here on as well.

Nonetheless, one could argue that credit growth for the largest of private banks and NBFCs is likely to remain somewhat tethered to nominal GDP growth plus several percentage points for market share gains. However, smaller, well-capitalized NBFCs have proven to be particularly agile. We expect the low bases they are growing from to be even more conducive to sustained long-term performance.

For example, Bajaj Finance (a diversified consumer NBFC which pioneered concepts like no interest EMIs for purchasing electronics) has grown loans almost six-fold in five years; profits have grown at a 39% CAGR, driven by cross-selling within their franchise -- 57% of disbursements are repeat clients with more than three products per customer. This is commendable given that acquiring customers is an expensive ordeal. Despite significant disruption (demonetization of 86% of currency), recent results have been solid by almost every parameter. With market share of merely 0.6% we are optimistic about their prospects.

It is hard to disagree that the degree of success of any business is dependent on several external factors. However, we believe perhaps ironically that agile financials have a strong hold on their own financial destinies (barring extreme scenarios which are a small fraction of possible alternative outcomes). Their performance during the recent demonetization has been another testament to their resilience. While we are evidently optimistic over the long haul, studying the best of these businesses has shown us that they have performed robustly despite strong headwinds even in the medium term. We believe that in adversity their recovery periods to normalize and resume growth have gotten progressively shorter as processes have grown more iterative and experiences dealing with distress have improved. As is often the case in our business, the most vexing times have also been the most opportune. This certainty factor plays an important role in our long-term conviction in a handful of these companies.

The very nature of financials make the high-quality ones particularly exceptional capital allocators. While good businesses earn juicy returns on capital, great ones have plenty of opportunities to reinvest the incremental capital at equally compelling rates. The great financials, depending on the nature of their businesses, earn ROAs of 2.5-4.0% and ROEs of 17-30%. Given the longevity of the growth runway, they are able to reinvest the bulk of their earnings back into the business at attractive returns. We have usually been advocates of them retaining more and paying out less. For example, Gruh Finance has earned ROEs of 32% and reinvested 60% of earnings in recent years. This has led to a phenomenal result -- over six years shareholders' equity has more than tripled and the company continues to earn the same high returns on equity on this much higher base -- a true compounder! We would much rather they retain 15-20 percentage points more and earn 32% on it rather than paying it back to us.

Gruh has a wide moat in form of the domain expertise associated with lending to lower-income families for purchasing affordable homes without conventional documentation proof (milkmen, vendors and painters usually don't file taxes). Deep understanding of cash flows associated with such professions is key to underwriting sensibly and managing credit costs. In a low ticket-size and granular business, operational and collection costs can take a real toll. Despite this Gruh exhibits deep operational frugality.

Gruh's leverage is typically higher as the product is a first-and-only secured mortgage for an owner-occupied home. Typically a ~US$11,000 loan is used to finance the purchase of a ~US$20,000 home. The low credit costs (Gross NPAs ~60 bps fully provisioned) due to disciplined underwriting, efficient collections and industry-leading cost control allow Gruh to earn a higher ROA while competitors deal with prohibitively high operational and credit costs.

Mr. Market has usually appreciated the qualities of such businesses once performance is evident. This has allowed select financials to raise incremental growth capital if required on exceptional terms -- at many multiples of book value! Time has shown that due to the sustained high-quality performance of such financials even subscribers at higher multiples have often gotten a great deal in hindsight.

The underlying source for high ROEs is different for each financial -- given its product mix, Bajaj Finance earns a higher ROA of >3% (derivation below).

Bajaj Finance reinvests >85% earnings at rates >20%. Reiterating this result for decades has been the source code for all great financial compounders.

Of course, not every bank or financial is an emerging HDFC Bank or Bajaj Finance. For every potential compounder there are several certain capital destroyers. We have usually steered clear of segments like gold loans, microfinance, infrastructure, construction equipment, and commercial vehicles -- from what we have learned some of these businesses are far more difficult to differentiate on and build superior operating cost structures or witness credit costs meaningfully lower than peers; others are more prone to excessive regulatory oversight or poor consumer credit discipline. Some of these segments have become more commoditized with more credit supply chasing stalling demand. Managements which have exited such segments have sometimes commented, "That was a mediocre business in good times and a terrible one in tough times." We highlight a snapshot of one such business (name withheld -- our intention is neither to malign nor embarrass -- these are usually good people in tough circumstances).

At Financial "A", credit costs escalated due to distress in their core markets, customers became delinquent very fast -- provisions ate into profitability. ROAs and ROEs compressed significantly. Management has struggled to create any real differentiators which can trickle down to the numbers that matter. These businesses have depended on blue sky scenarios to do well and tougher times have been largely unforgiving to their profitability. The opportunity costs for investors in such businesses have often been very high.

In searching for opportunities we look for the basic ingredients of a successful compounding recipe. Ultimately we are trying to ascertain the source of competitive advantage in each vertical and for the cumulative franchise. Such edge may emanate from several sources and will eventually show up in the numbers. For example, edge may meaningfully affect the ability of a financial to lend competitively yet experience below-peer credit costs (lower NPAs and provisions), or grow efficiently (strong loan growth) yet have lower operational costs (declining cost to income) than competitors, or earn better yields (higher net interest margins) on product innovations that competitors find painful to replicate (higher upfront costs and NPAs). It's usually not real edge unless it has a meaningful impact on ROA. While these are quantitative measures they have their underpinnings in management's decision making. Invariably, the largest contributor to the business' future value boils down to a qualitative measure -- management quality. It may be absolutely crucial for businesses yet developing moats and less so for deeply entrenched businesses.

Typically we want to own financials in businesses that we are able to understand but competitors find difficult to execute. The prevailing rates on assets and liabilities are largely market determined -- hence an NBFC's ability to operate efficiently, acquire customers inexpensively, streamline distribution, underwrite rationally, keep credit costs low, are all sources of advantage. Clearly certain product lines are better suited to long-term success than others -- we've preferred businesses focusing on retail segments -- housing, small business, personal, consumer loans for durables, electronics & lifestyle products -- these are more granular businesses which make them adaptable to differentiate on technology, product innovation and many small operational improvements over competitors -- also they are largely under-penetrated segments country wide. Dozens of such "mini-moats" add several basis points to operating results. A great example of the cumulative effect of doing things that are simple but not necessarily easy.

The banks and financials we have owned over time have been incredibly forgiving in one more aspect. We are notoriously poor market timers (not that we make any attempt). We often mock ourselves at how we've often bought stocks when prices were at 52-week highs. This has led to the origin of a new phrase in our discussions -- "Own companies which allow you the privilege of buying high and selling low!" Though we are rarely sellers of great companies we want to own businesses which allow you to buy at 52-week highs and sell at 52-week lows and still earn a great return -- given that the magic of compounding is allowed to work for several years in the interim.

Against this rather wordy backdrop, I look forward to share the optimal 'setup' we seek while scouting for Indian financials which have the potential to emerge as great long-term compounders for patient allocators. We also look forward to sharing such an idea (not mentioned above) at Asian Investing Summit 2017 on April 4-5.

Sources: Capitaline Plus, HDFC Bank Annual Reports; Kotak Mahindra Bank Annual Reports; Bajaj Finance Annual Reports; Gruh Finance Annual Reports; Bajaj Finance Investor Presentations; Kotak Mahindra Bank Investor Presentations; Report on Trend and Progress of Banking in India (Reserve Bank of India); Reserve Bank of India Database; DMZ Partners estimates.

Disclosures: Positions held by DMZ Partners or associates may be inconsistent with views mentioned herein. DMZ Partners or its associates accept no liability for any errors or omissions in the given content. The material presented herein does not constitute a recommendation or offer for the purchase or sale of any securities and is provided solely for informational purposes. DMZ Partners offers no investment related products or services whatsoever. Please consult a certified financial advisor before making investment decisions. Unauthorized usage, alteration or distribution of this information is prohibited.

Soumil Zaveri moved to the US in 2005 to study Economics and Biology at Duke University, in North Carolina. He had the good fortune of being taught by phenomenal professors including Dr. Emma Rasiel. At Duke he presided over the Investment Club with, now good friend, James Schulhof. In the summer of junior year, He interned with Goldman, Sachs & Co. in New York on the healthcare team with in the Research division. He was extended a full time offer and joined the banking team there after graduation. He witnessed an exponential learning curve while working with Richard Ramsden, Brian Foran, Quan Mai & Ryan Fulmer through the financial crisis. Given the magnitude of changes affecting the western economies, the resilience of Asian ones and his desire to be back home, after a few years in New York, he moved back to Mumbai to start his own investment firm, and to work directly on allocating personal and family capital.

DMZ Partners was founded on 1st April 2011 as a partnership firm. His grandfather, who was very fond of him, was Dinesh Mahsukhlal Zaveri (initials DMZ), and co-incidentally his father’s great grandfather who was a successful businessman of his time, Dahyalal Makanjee Zaveri also carried the same initials.

On the Valuation of the Indian Stock Market

By Samit Vartak, a featured instructor at Asian Investing Summit 2017

To start with, let me admit that even though I have done professional business valuation for many years, valuation in the stock market is a very different ball game. Here it entails some science, but a whole lot of art and when you talk of art, it involves a lot of subjectivity and with that a wide range of possibilities. So let me provide my “subjective” views on current valuations with support of few factual data points. Again to repeat, the views I had presented in October 2015 and January 2016 newsletters are still applicable as nothing significant has changed since then other than the increased uncertainty about the near term.

Valuation Multiples Have Expanded in the Last Three Years without Earnings Support

If we analyze valuation levels since the peak of previous economic cycle in 2008, the rise in multiples started from the last part of 2013. During 2009 to 2013, valuations were reasonable in most of the sectors. Few anecdotal evidences are in NBFC sectors where many high quality companies were available at trailing P/B multiples of below 2x. If you compare now, those multiples have moved upwards of 3x and many above 4x. Similarly if you look at some of the branded building materials/commodities or quality auto ancillaries or specialty chemicals with ROE/ROCE > 20%, many were available at trailing PEx of at or below 20x. Now most of them are trading at multiples upwards of 30x. I can talk about many such sectors where in reality the growth has significantly gone down over the last 3 years but the multiples have expanded by 20% to well above 200%.

Let me substantiate the above with some statistics and evaluate how the entire market has done over the 3+ year period since PM Modi was selected the BJP candidate in September 2013. Even though I am picking just one starting point, valuations were similar or more attractive during most of the 2009 – 2013 period. If I were to analyze the performance (Aug 30, 2013 to Dec 16, 2016) of the roughly 1700 daily traded companies and rank them by market capitalization as of August 30, 2013 the picture looks as below. I have excluded the banks given that some of them have reported huge losses and they tend to skew the valuations.

As you can see, the returns have been almost entirely because of PEx expansion and that is also inversely proportionate to the size of the companies. Worse is that the earnings growth has also been inversely proportionate to the returns. Simple average returns are stellar for small cap companies. If you had invested equally in the small cap companies beyond the top 500, you would have returned 356% (i.e. multiplied your investments by 4.56x), whereas if you had invested equally in the top 100 companies, the returns would have been only 73%.

Last 40 months have rewarded one in proportion to the risk he/she has taken and very few have lost money given the broad based nature of stock returns. Money follows returns and domestic money has followed the non-large cap stocks. Many domestic investors are first time investors in the stock market as returns from fixed deposits, real estate and gold have fallen and equity investment has caught the fancy. Many fund managers have been claiming that they have beaten the indices and though it’s factually true, it hides one big parameter. “How much was the risk taken to get those returns”? In good times these facts are ignored by the investors and undue credit is taken by the fund manager.

Risks to Current Valuation Levels

There are two key factors for stock values viz. earnings and PEx. Risk comes from either of the two contracting. Earnings contraction can occur due to topline de-growth or margin contraction. When margins reach peak levels during economic boom the risk of contraction increases from those elevated levels. Similarly PEx contraction risk increases the further it moves above the averages. Case in point are two extreme instances, first in Jan ’08 when PEx as well as margins were at historical highs and second in Mar ’03 when both were at near historical lows. Accordingly risks were the highest in Jan’08 and lowest in Mar ’03.

As you can see in the above graph, currently the PEx is closer to the highs, but the margins are closer to the lows. Hence the risks are balanced given that possibility of PEx contraction can be counter balanced by either margin expansion or topline growth or both. We had seen the margins expanding over the last year (reaching 5.4% from trough of 4.6% reached in FY15) and gaining momentum in the first two quarters of FY17, but the currency replacement action has broken that momentum and has in fact increased the probability of margin contraction. Margins are vulnerable to increase in commodity prices (industrial metals, agriculture and energy) as well as operating deleverage from possible drop in capacity utilization.

Rise in Uncertainty

I believe that cash replacement is just the beginning of crackdown on unaccounted income/cash and many more steps would be needed to seriously reform the corrupt system. This backdrop and changing global scenario has increased the uncertainty for the markets. We need to closely watch for upcoming headwinds such as:

  • Increased focus on tax compliance would mean tax avoiding informal sector (accounting for 75% of employment in India) to shrink resulting in widespread job losses before the economy evolves a new ecosystem. Only fraction of these jobs would be absorbed by the formal sector.
  • In a weak demand environment, commodity prices (20-100% increase over last year in industrial metals and rubber) have jumped and in this environment the ability of companies to pass on the cost increase is limited. Low commodity prices had helped companies improve gross margins in the recent few quarters. There is risk of this benefit reversing.
  • In an evolving environment, companies would postpone their investment plans thereby slowing job growth. Capacity utilization has been near historical lows at around 70% and this had impacted investment cycle even before the recent disruption. Reduced money supply generally has negative multiplier effect on the growth.
  • Government seems to be serious in dealing with tax evaders and cash hoarders. Assets such as properties and gold were the hiding places for such wealth. With many having to pay significant taxes on hoarded cash and at the same time physical assets like properties loosing value, wealth of many would be destructed. This along with many having to face tax scrutiny may have negative wealth effect thereby impacting spending for some time.
  • GST roll out is also potentially disruptive in the initial phase. There will be de-stocking of the channel in many sectors where taxes are expected to drop. This will happen just before the implementation of GST and it may take time for many smaller companies to be ready with the back end needed to handle the new tax system, thereby delaying growth.
  • Globally, with new regime starting in the US there is huge uncertainty regarding trade policies that could disrupt global trade flow and force countries to evolve new models for growth.

Massive Opportunities Await in the Long Term

  • The incredible growth in cash component (30% CAGR vs. less than 14% CAGR in nominal GDP) during this century had inflationary effect on many hard assets such as land and property. Inflation also kept the interest rates elevated. Both these have acted as added cost burden on companies who want to invest thereby impacting capital expansion and employment growth.
    • With government’s intention to reform the cash economy, the hope is that land/property prices would come down significantly
    • GST roll out is expected to make India a uniform market without state border bottlenecks in terms of time and cost
    • Above two are the biggest reforms in India’s modern history and have the potential to make India extremely competitive in the global manufacturing chain and help create global scale businesses.
  • With transfer of wealth from informal to formal economy, government tax collections would significantly improve and if they allocate that capital efficiently (subsidy, infrastructure spend) India could transition into a much higher growth trajectory.
  • Formal and transparent business practices would incentivize foreign investments and boost capital expenditure thereby employment growth.

Conclusion on Valuation

Valuations in the non-large cap stocks are discounting a lot of hope. I believe that the uncertainties have increased over the past two months and resultantly the re-start of growth phase for corporates is pushed out. In such environment, there is risk of not only multiples but also earnings contracting. It is time to be extremely careful in picking the right businesses and absolutely not the time to overpay. We have to be open to the possibility that sometimes what’s good for the country and overall population may not necessarily be rewarding for the stock market. Historically we have seen best of market returns under worst of governments and vice versa.

This post has been excerpted from a letter of SageOne Investment Advisors.

Read a related article by Samit Vartak.

Samit is one of the founding partners and Chief Investment Officer responsible for ensuring SageOne’s adherence to its core investment philosophy and discipline of risk management. His focus is on building long term wealth for the clients even if it means sacrificing short term money making. He believes in risk management not by seeking extreme diversification or buying sub-par businesses at low multiples, but by building a reasonably diversified portfolio of high quality businesses having long term competitive advantages in attractive and high growth industries.

Samit returned to India in 2006 after spending a decade in the USA working initially in corporate strategy with Gap Inc. and PwC Consulting, and then with Deloitte and Ernst & Young advising companies on business valuation and M&A. This experience forms the backbone that helps him better understand businesses and their fair value. Samit is a CFA® charter holder, an MBA from Olin School of Business of the Washington University in St. Louis and holds a Bachelor of Engineering degree with Honors from Sardar Patel College of Engineering (SPCE), Mumbai University.

Emotional Tenacity and Deep Value Investing

By Peter Kennan, a featured instructor at Asian Investing Summit 2017

One of the challenges of traditional deep value investing is not knowing whether market price and fair value will converge during one’s investment time horizon. At Black Crane, we use our corporate finance expertise to identify and/or create events that close the valuation gap.

However, the Black Crane approach involves being prepared to go the journey with the companies in which we invest. We always invest in companies with solid assets and/or businesses; however, we typically invest at times of significant uncertainty, when negative events have significantly depressed a company’s share price and traditional investors have ‘headed for the hills’.

To take such contrarian positions requires conviction in one’s research and emotional strength to withstand the negative noise that surrounds such situations. In fact, the best opportunities to make outstanding returns arise when stock prices fall significantly post our initial investment. It is at this point that our conviction is most tested. Are we prepared to follow our research and invest further at lower prices including providing primary capital?

When entering an investment that has the potential for significant short-term drawdowns, we reserve capacity to invest more, enabling us to be opportunistic in tough and uncertain times during the life of the investment.  This is a key element of our strategy and has significantly added to our returns over time.

Executing such a strategy requires us to have investors who understand our approach and who are prepared to go the journey with us.

An example of this approach is our investment in Elders hybrid securities. Post investment the price of the hybrids fell from approximately $30 to a low point of $8.50. We reduced our average entry price to $22. The NAV of the fund declined 8% during this period. The decline in the price was due to interim events that were perceived by the market to be very negative. Drought conditions extended for a second year and the sale process for the core business was not successful. In our judgment based on our extensive research, these were temporary setbacks and not permanent impairments to our investment thesis.

A critical element to maintaining a strong state of mind during such periods is the depth and quality of the research performed up front, prior to investment. As part of this, it’s essential to have role played potential negative scenarios: How would you feel if this happened? What would be the effect on value? What would your response be?

In the case of Elders, the response was to buy more hybrids, decreasing our average entry price and increasing our negotiating leverage with the company as our position increased from 15% of the hybrids on issue to 30%.

Six months after this low point, the rains returned, management invigorated by their continued independence reduced overheads and restored the business to health. A further 18 months later, the company acquired all our hybrids at $95. Black Crane made more than four times its money and the position turned around from negative 8% attribution to fund NAV to positive 44%.

Editor's note: Listen to Peter's presentation on Elders at Asian Investing Summit 2014, when the hybrids still traded slightly below Black Crane's average entry price of $22:

Black Crane has a highly concentrated portfolio of 6-8 investments. This allows us to know our positions intimately and to have the mental capacity to deal with tough situations should they arise. We focus on solid quality businesses and assets so the fundamental risk of the strategy is low.  Whilst the concentrated portfolio can result in lumpy returns in the short term – making strong underlying conviction essential - returns are reliably positive over our investment period.

The human psyche likes consistent month on month returns and emotionally processes mark to market losses as real losses, notwithstanding the logic that they are not. Being prepared to be highly concentrated and to weather short-term drawdowns leads to superior risk adjusted returns. In essence, we are taking a private equity approach to listed investments.

Peter Kennan is Managing Partner and CIO of Black Crane Capital. He has 15 years of corporate finance experience across a diverse range of sectors and transactions with UBS Asia and Australia. With UBS, Peter was formerly the Head of Asian Industrials Group for UBS Asia, a corporate finance sector team covering energy, infrastructure, resources, consumer/retail and general industrial companies. He achieved number one team rating in Asia with revenues of US$400 million in 2007, grown from just US$20 million over a four year period. Peter was also the Head of Telecoms and Media sector team for UBS Australia specializing in M&A, advising on many large, complex transactions. Prior to UBS, Peter spent 7 years with BP in a variety of engineering and commercial roles.