Is Rerating on The Cards For This Undervalued NBFC? 

Hi guys, This is Aditya Vora here...

A few years ago, when I began a carrier in equity research, my first job was at a leading domestic brokerage house.

One of the many things I learnt from market veterans there, was the concept of sector rotation or investing in sectors which are in flavour.

My head of research shared an important concept about investing in large-cap stocks.

The difference between the fund managers of largecap mutual funds outperforming or underperforming each other is not as much dependent on stock selection but more about assigning weights to sectors.

In simple terms it's all about how much 'overweight' or 'underweight' you are on a particular sector. This is because the stocks largecap fund managers invest in are mostly the same.

After all, you can't experiment a lot when it comes to the largecap space. The best you can do is take a call on which sector will be in flavour over the next couple of years.

Think of it this way...

Fund Managers and CIOs of reputed mutual funds are known not for individual stocks but their sector calls.

Take the example of HDFC MF star fund manager Prashant Jain. He made a bold call betting on PSU stocks and public sector banks in the early part of the last decade. Unfortunately for him, he was ahead of the curve.

It's no wonder that a majority of largecap HDFC schemes underperformed the benchmark indices.

Now take the example of S Naren, the CIO of ICICI Prudential mutual fund. His largecap funds were overweight on the power sector in 2019.

His logic stemmed from the fact that the power and utilities firms had seen no earnings growth over the past 10 years. If market leaders were available close to book value, then they sure have the ingredients to create wealth.

And sure enough, stocks like NTPC and Power Grid doubled.

The point I'm trying to make is that as an investor in large-cap stocks, it's pertinent to focus more on the sector than on specific stocks. Instead of picking stocks, focus on an industry which has multiple tailwinds. Then look to invest in 4-5 goods stocks in that sector.

Why 4-5 stocks?

Last year the PSU banking index doubled. Imagine if you got that sector call right but only bought SBI. While SBI gave a 31% return, stocks like Bank of Baroda and Canara Bank doubled. So buying a basket of stocks in the industry you think is going to be an outperformer makes a lot of sense.

Now, the strategy is fraught with risks. What if the sector doesn't perform and you own multiple stocks from the sector?

You will underperform...badly.

While banking was the star in 2022 and continues to do well, the valuations of the stocks, especially of the private sector banks, have started to look high.

The table in the slide clearly shows the sharp run up in banking stock valuations. I mean we are not at a stage where the banking stocks are extremely expensive but gone are those days where the margin of safety was huge. All of them are trading at a premium to their 5 year price to book ratio.

With banking stocks a tad bit expensive, my attention fell on NBFCs which are nothing but a subset of the banking space. If you go to see, almost the same tailwinds apply to the NBFC space as they do to the banks.

In that case, why not look at NBFC stocks?

If you look at the valuations, many smaller NBFCs are still available at a discount to its 5-year median valuations. Some are in fact available below or close to their book value.

If you look at the table in the slide, leaving aside Bajaj Finance which trades at 8 times price to book and Mahindra Finance which is at a premium to its 5 year average valuations, the other 2 stocks are actually cheap.

Looking at LIC Housing Finance and L&T Finance, the combination of sector tailwinds + cheap valuations merit look.

Before I talk about LIC Housing Finance, let me talk about the banking industry tailwinds and why I believe they are more favourable for the NBFCs rather than banks going ahead.

To give you a background, since the IL&FS crisis of 2018, the banking sector's fundamentals have become resilient. Slowly but surely, things have fallen in place.

Inflation has likely peaked. The interest rate cycle likely to have peaked along with it. There is high liquidity in the bond market. This enables NBFCs to borrow funds comfortably.

And last but not least, asset quality levels are looking good.

While the repo rate increased by 2.5% since FY22, the three-year corporate AAA rated bond yields have gone up by just 1.6%.

Also, the MCLR (marginal cost-based lending rate) which is the rate at which the NBFCs borrow from banks, has gone up by just 1.35%.

This partial transmission of higher interest rates had helped NBFCs manage their costs and net interest margins.

When interest rates decline going forward, NBFC will shift their borrowings from banks at the MCLR, to the bond market. This is because the 3-year AAA rated corporate bonds are at a discount to bank lending rates.

With abundant liquidity, I don't see why the cost of borrowing for NBFCs should go up.

So the question is when will perception move in favour of NBFCs?

I believe the NBFC dominance over banks in terms of fundamentals will start when the interest rates start going down during the latter part of the year.

The decline in the repo rate will be a game changer for NBFCs. Banks have 30-40% of loans linked to the repo rate. NBFCs have a large proportion of fixed rate loans. This will aid margins when borrowing costs for the banking industry starts to come down.

While banks had a stellar run in 2022, some NBFCs, despite the industry tailwinds, are available at dirt cheap valuations. Despite a decent run up, many NBFC stocks are available at valuations below pre-covid levels.

And now coming to the stock in contention... LIC Housing Finance.

It is said that in banking, the growth problem can be resolved but the asset quality problem is a bigger mess.

However, LIC Housing Finance problem is growth and not asset quality.

Loan growth has been barely 4% CAGR over the past 5 years. Net profits have also grown at a disappointing 4% CAGR over the past 5 years.

The return on equity which was 15-16%, five years ago, has come down to 12% in FY23.

However, from a margin perspective, things are gradually improving. The company closed FY23 with a net interest margin of 2.9%. The full financial year net interest margin was 2.4% as against 2.2% a year ago.

When we talk about NPAs, I don't see that as a too much of a problem, with net NPAs hovering around 2.7%. The problem is just bad financials which led to valuation multiple de-rating over the past 5-7 years.

No wonder the stock is available at 0.7 times the book value which is a 30% discount to its median valuations. And of course, the stock has a 2.5% current dividend yield.

In my view the day growth starts coming in and the company does something to arrest the falling market share, the stock will re rate.

The risk reward ratio is very favourable for a strong company like LIC Housing finance which is available at dirt cheap valuations.

In my experience, when industry tailwinds are strong, market leaders are the first ones to benefit, followed by the laggards.