Sometime back we had written about this Formula for Exponential Returns in Lending Stocks, wherein we had highlighted how having a growth rate higher than ROE and a high valuation multiple is the best combination in lending stocks. Recently we were looking into newly listed SBFC Finance; the high growth rate of >40% attracted us here. But after taking an over view of key metrics, something seemed off.
What you have assumed is an ideal world where the management is capable of underwriting where they dont make bad loans. Didnt PNBHFC, Indiabulls Hsg blow it up? I am not even talking about DHFL. Any day a lower leverage is better. There are other components to improving ROE. A good lender should try to use it. But being a commodity business, contributions from other components cant be too high. A few examples here and there e.g IDFC first bank have high NIMs which can translate into higher profits and hence higher ROEs etc. Idfc first has its own issues. I was just giving an example.
The focus area of the post is to highlight the issue of low leverage & low ROE; there are obviously various other possible issues like asset quality, yields, slowdown in growth etc.
Higher ROE can come from improved ROA. And in this case as highlighted, even if we consider that ROA will improve to ~5% over next 3-years, still the growth in book value if ~20% CAGR, which is half of loan book growth rate.
As you have shown in your table, the leverage itself is increasing as a consequence of higher growth rate and hence higher ROEs. Most lenders can grow their book. Hence all of them are interconnected. But all the growth is not going to be value accretive.( Why else do you think RBI steps in time to time? AUBANK has been showing high growth rates that raised suspicion and RBI had to step in.) High loan book growth increases leverage, which in turn increases ROE(refer to your table). I believe you have not assumed any other improvements like higher NIMs, higher NPMs etc. At higher growth rates, typically reckless lending happens which leads to writes-offs, provisioning etc and hence lower PAT, which in turn leads to lower ROEs. Lot more value gets destroyed due to PBV multiple also getting de-rated. Hence I would prefer a lower-medium growth rate, that keeps leverage in balance and results in a value accrual.
This is what my understanding & experience has made me believe on what leads to high returns or low returns in lending stocks. You can have your own understanding.
Have always loved the Gruh's model of low spreads, high growth, great asset quality and high leverage. Obviously being an HFC the leverage could be raised to very high levels which would not be the case for other loan products.
Better to go with proven names that can deliver strong growth & leverage their balance sheet well, rather than going for unproven names while expecting them to maintain controlled or low leverage.
What you have assumed is an ideal world where the management is capable of underwriting where they dont make bad loans. Didnt PNBHFC, Indiabulls Hsg blow it up? I am not even talking about DHFL. Any day a lower leverage is better. There are other components to improving ROE. A good lender should try to use it. But being a commodity business, contributions from other components cant be too high. A few examples here and there e.g IDFC first bank have high NIMs which can translate into higher profits and hence higher ROEs etc. Idfc first has its own issues. I was just giving an example.
The focus area of the post is to highlight the issue of low leverage & low ROE; there are obviously various other possible issues like asset quality, yields, slowdown in growth etc.
Higher ROE can come from improved ROA. And in this case as highlighted, even if we consider that ROA will improve to ~5% over next 3-years, still the growth in book value if ~20% CAGR, which is half of loan book growth rate.
As you have shown in your table, the leverage itself is increasing as a consequence of higher growth rate and hence higher ROEs. Most lenders can grow their book. Hence all of them are interconnected. But all the growth is not going to be value accretive.( Why else do you think RBI steps in time to time? AUBANK has been showing high growth rates that raised suspicion and RBI had to step in.) High loan book growth increases leverage, which in turn increases ROE(refer to your table). I believe you have not assumed any other improvements like higher NIMs, higher NPMs etc. At higher growth rates, typically reckless lending happens which leads to writes-offs, provisioning etc and hence lower PAT, which in turn leads to lower ROEs. Lot more value gets destroyed due to PBV multiple also getting de-rated. Hence I would prefer a lower-medium growth rate, that keeps leverage in balance and results in a value accrual.
This is what my understanding & experience has made me believe on what leads to high returns or low returns in lending stocks. You can have your own understanding.
Have always loved the Gruh's model of low spreads, high growth, great asset quality and high leverage. Obviously being an HFC the leverage could be raised to very high levels which would not be the case for other loan products.
Better to go with proven names that can deliver strong growth & leverage their balance sheet well, rather than going for unproven names while expecting them to maintain controlled or low leverage.