This Sector Will Rise Like a Phoenix from the Ashes of Demonetisation - The 5 Minute WrapUp by Equitymaster
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This Sector Will Rise Like a Phoenix from the Ashes of Demonetisation

Dec 20, 2016
In this issue:
» Currency Replacement: Pacing up?
» Surge in Agricultural Commodity Prices...
» ...and more!
00:00
Kunal Thanvi, Research analyst

It's a sunrise industry growing at well over 50% annually.

It's lifting thousands of rural folk out of poverty.

It's a direct play on India's 'bottom of the pyramid' story.

It employs about 1.2 million people.

It will likely produce many multibaggers over the years.

There's just one problem...

Most transactions in this industry are made in cash.

I'm talking, of course, about microfinance.

As promised, today, I'm taking our demonetisation sector series forward. Last Tuesday, I wrote about the auto sector. Today, we'll take a look at what could be the second worst-hit industry (after real estate) due to demonetisation.

The business model of a microfinance institution (MFI) is simple enough.

The MFI sends its representatives to a village. They get the women folk together and explain the many small business opportunities available to them and how the MFI can finance them.

The interested women form a group of four to ten. This is called a joint liability group (JLG) in MFI jargon. A few JLGs from the village come together and apply for a loan. Their sources of income could be raising cattle, sewing, running kirana shops, working on farms, selling fertilisers, among others.

Average ticket sizes rarely exceed Rs 25,000, and the repayments are mostly in cash. Defaults are rare as most JLGs repay on time.

But demonetisation has changed this story.

The women's income has fallen due to the lack of cash to pay them. Thus, JLGs are finding it difficult to make payments to MFIs on time. Repayments have been delayed and the risk of default has gone up.

MFIs have stopped disbursing loans due to lack of liquidity. They even had to approach the RBI for relief.

The cash situation is so tight that MFIs are bypassing banks. Instead of depositing repayments into their bank accounts, they are hoarding the cash and then disbursing it directly to JLGs.

Even rating agencies have taken note. Downgrades of MFIs have already begun.

We travelled to north India to meet an MFI. This company boasts of NPAs among the lowest in the industry...and loan book growth among the highest.

But after demonetisation, they had to stop lending temporarily and relax their recovery schedule. There was simply no cash in the system.

The management said it could take five to six months for the cash situation to get back to normal. Two other MFIs told us the same thing.

This mess will need at least a few months to sort out. Some of the larger MFIs (like Equitas) will become small finance banks. There will be a push towards cashless transactions as well. The industry could witness consolidation.

The fact is that demonetisation is a game changer for the sector. Some of the smaller MFIs may not survive.

So does this mean that the microfinance story is over?

No.

There is absolutely no chance the microfinance industry will disappear in India. These institutions are deeply tied to the rural and informal sectors. Continued strong growth is inevitable.

The problem at the moment is that cash - both the raw material and finished good for these institutions - is not sufficiently available. However, once the currency in circulation normalises, the industry will recover.

The challenge for long-term investors is two-fold:

  1. Identifying the strongest listed players
  2. Investing in them without compromising on margin of safety

Most the listed MFIs are small caps. The Hidden Treasure team is on the hunt for the ones that will rise like a phoenix from the ashes of demonetisation. The team's latest recommendation was not a MFI stock. But if the correction in these stocks continues, subscribers can expect a well-selected pick.

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------------------------------

03:45 Chart of the Day

The demonetisation has left a lot of questions unanswered. Everyday there is something new that is brought into the public domain.

Earlier, the question uppermost in everybody's mind was - 'The impact of demonetisation on the economy'.

That said, with a goof up in implementation, the key question has changed. It is - 'When will things go back to normal'.

Vivek Kaul, at the beginning mentioned that the cash shortage situation to return to normalcy would require around six months.

However, if SBI is to be believed, normalcy would return by the end of February 2017.

The current strain on liquidity is due to two reasons. First, bottlenecks in printing notes. Second, unavailability of Rs 500 notes.

Demonetisation: Expected Currency Replacement by Feb 2017

Note: Scenario 1: Only Rs 500 notes are printed; Scenario 2: Smaller percentage of low value notes are printed; Scenario 3: Higher percentage of low value notes are printed;

The unavailability of Rs 500 notes has led to a big gap between the highest (Rs 2000) and next highest (Rs 100) denomination currency notes. It means Rs 2000 notes are more of a store of value item.

Result: The printed currency is also facing problem in circulation.

Now, if SBI's research statements are to be believed, the printing of Rs 500 has speed up. And in the best case scenario the situation will be back normal by the end of February 2017.

The three scenarios on the idea of aggressive printing of Rs 500 notes:

  • If during December-February only Rs 500 Notes are printed - 98%
  • If during December- January only Rs 500 notes are printed and in Feb 50% of notes are printed in Rs 500 and rest all in small denomination - 88%
  • If during December- January only Rs 500 notes are printed and in February only small denomination notes are printed - 78%

Even we take the worst case scenario, 78% replacement will be more than the current expectation. If it pans out this way, it would be a big relief for Microfinance sector.

As discussed above, cash is both the raw material and finished goods for these Institutions. This can act as a catalyst in the recovery of the sector.

04:30

The agricultural commodity prices are on the rise. For CY16, Wheat, Jeera and turmeric are up by 24%, 23% and 22% respectively.

Wheat prices touched an all-time high of Rs 2,175 per quintal in 2016. The spot prices in northern states surged to Rs 2,100-2,150 per quintal from Rs 1,600 per quintal in last Rabi Season.

In September to cool down the wheat prices, government lowered import duty to 10% and then exempted it altogether.

The rise has been due to basic fundamental reasons i.e. tight supply and high demand.

It is not just the quantity, there is increasing awareness about the quality of crops as well. Farmers can no longer afford bad and sub-standard crops. This increased awareness towards good quality agricultural output has given rise to a select group of companies specializing in this niche.

Our The India Letter team has always been at the forefront of finding such niche business with phenomenal track records.

The team has zeroed in on one such company which provides farm solutions to farmers for improving the quality of their output. With strong R&D, distribution and supply chain arrangements, the company leads the market.... Keep an eye out for the next recommendation from The India letter team to read the detailed report on the company.

04:45

In the meanwhile, the Indian indices have extended their downtrend trend during the noon trading session. Sectoral indices are trading on a mixed note with banking and metal stocks leading the losses, while IT stocks are in demand.

The BSE Sensex is trading lower by 88 points while the NSE Nifty is trading lower by 26 points. The BSE Mid Cap index is trading down by 1% while BSE Small Cap index is trading down by 0.6%.

04:55 Today's Investing Mantra

"Be fearful when others are greedy, be greedy when others are fearful" - Warren Buffet.

This edition of The 5 Minute WrapUp is authored by Kunal Thanvi (Research Analyst).

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