A recent news report in BusinessLine observed that the current market capitalisation of non-banking finance companies (NBFCs), which was just half of that of public sector banks in 2006, has, in a decade since, grown to be twice that of the latter.
In valuing these companies collectively at four times what they were worth ten years ago, the stock market has not been swept away by hype or false promise. Its valuation is based on solid underpinnings to business fundamentals.
As the news report also pointed out, a sample of 33 top NBFCs saw their net profits grow at a compounded annual rate of 23 per cent. This is practically on par with the growth of even private sector banks, which were slightly ahead, at roughly 24 per cent in compounded annual growth.
If this is not awkward enough for public sector bank managements, there is more for them to reckon with. It would seem they don’t fare any better than even smaller (by loan assets) rivals in the private sector. The latter set of banks, valued collectively at twice that of public sector banks as of March 2015, have since grown to 2.5 times by March 2016.
Market capitalisation, as finance theory holds, is the present value of all future cash-flows that accrue to shareholders from the business operations of an enterprise. In the event, the stock market believes such cash-flows of select NBFCs in the aggregate, will be twice that of public sector banks. Even more remarkable is that these NBFCs have registered such a high rate of growth despite their relatively meagre market share in the financial sector’s loan assets.
NBFC share in financial sector
According to a PriceWaterhouse research report, the share of the non-banking finance industry as a whole was a mere seventh of the total assets employed in the nation’s banking industry as of 2014. Even if that number is somewhat dated and the current NBFC share of total financial sector assets had indeed gone up, it is fair to say that it can’t be higher than a fifth of the total. A market capitalisation that is twice as large as that of PSU banks with lendable resources that are only a fifth of the total, means just this: NBFCs generate 10 times as much cash-flow from a rupee of shareholders’ funds than the public sector banks are likely to do over an extended time into the future.
How could this be so? Granted that private entrepreneurs are savvier than their public sector counterparts in seeking profitable opportunities. They could also be better judges of the credit risk inherent in a loan proposal and may, hence be better able to steer clear of dodgy loans. But it still defies one’s comprehension that such outperformance can be as high as ten times. What, then, explains such a huge divergence in performance?
It could be argued that markets tend to be overly optimistic about the prospects of private enterprises than public sector ones. This is valid to a certain extent. In stock market parlance this is often referred to as an ‘ownership’ discount. But that can only be a partial explanation for what is undoubtedly a huge differential in profits from a rupee of shareholder investments. So, we need to dig a little deeper.
Huge NPA volumes
Perhaps, the size of shareholder funds deployed in the banking business by PSU banks is not as large as appears in their financial statements. This is most certainly true. It is now well recognised that the size of the non-performing loans in the balance sheets of PSU banks is a lot larger than what the system of accounting currently stipulates.
Now, if they are even 5 per cent more than what is currently estimated to be, that could virtually halve the shareholders’ funds. In the event, we aren’t looking at a fund size that is five times as big as that of NBFCs but only equal to it. That still leaves us with a performance differential (twice as profitable) that can only explained away as attributable to strategic choices made by enterprises with differing ownership characteristics.
Though some of the NBFCs, such as Housing Development Finance Corporation or Power Finance Corporation, are quite large and perhaps bigger than the smallest public sector bank, as a general rule, they are considerably smaller in their size and scope of operations compared to PSU banks. Now, smallness is at once an advantage and a disadvantage. Small players are nimble and quick to spot an opportunity. Consequently, it is not uncommon for smaller outfits to generate higher profits than their larger rivals. But they also suffer from a drawback; they are more vulnerable to even slight changes in the business environment that may affect their profits.
In the event, investors would subject such profits to a higher discount rate as their profits are subject to a greater degree of volatility. A large business is inherently able to withstand the ups and downs of a business cycle better than its smaller rival. The stock market recognises this. Hence, despite suffering a higher discounting of its future profits, if NBFCs are collectively able to demonstrate a higher volume of market capitalisation, it follows that the size of their profits in absolute terms is still robust enough to withstand the penalty of higher discounting.
What’s the USP?
That leads us to logically frame the next question. What is special about the NBFC business model that makes for a larger stream of cash-flows into the future compared to their banking counterparts in the public sector and, as a consequence, helps NBFCs command a higher valuation? Quite apart from the intrinsic differences in management style and business culture between the two, the most striking aspect of NBFC operations is that they are diversified in their loan portfolios, in a way that PSU banks are not.
The former’s diversification of loan portfolio is also not at the cost of forsaking their special advantage or superior skills in select areas of lending. Thus you will find that some NBFCs would concentrate on housing loans (HDFC) to the exclusion of practically every other type of lending opportunity. Similarly, other NBFCs only specialise in gold loans or collateralised consumption lending, leaving other areas of banking to larger rivals.
But the concentration of such lending is neatly balanced by a huge degree of diversification in the customer base. In contrast, banks, for all their emphasis on diversified exposure across sectors and industries, spoil their chances by weighting them in favour of big-ticket loans. If there is a systemic crisis within the economy, the diversified exposure involving big-ticket loans is actually detrimental to their interests.
Of course, banks cannot help being exposed to diversification risk. After all, somebody has to bankroll those mega projects in steel, cement, roads, and so on. But the market is an unforgiving beast. It doesn’t recognise that socially responsive lending should enjoy a concessional rate of discounting of future profits.