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:

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%.

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.