Podcast Overview –
In this podcast, we simplify the Banking and Financial Services Sector. What are the trends in BFS sector today? What factors should you keep in mind before investing in the BFS sector? Watch this video to get insights on the BFS sector by Rushabh Doshi from Proinvest Nirmiti.
Transacripts
[00:00:15.370] – Darshan Doshi
Hi, everyone. Welcome to Swatantra. This is a podcast series where we simplify investing. This is a podcast co-branded by Dasar and Proinvest Nirmiti. You know, the last time we did a sector deep down analysis with Rushabh, and today we are going to do another one with him on banking and financial sector. So, Rushabh, welcome. We’re going to cover, again a sector analysis with you today. I have some big data points before I kind of ask you a question, and that is, India, almost 40% of the Indian population, that is almost about 400 to 500 million people, according to the World Bank, do not have sufficient access to finances or access to capital. And the government of India has been focusing, the central government has been focusing on financial inclusion for a very long time. But it looks like we are still further away. What financial inclusion does is it brings more rounded holistic, economic development, economic growth, and it really uplifts the poor. According to another report, 20% of India’s population lives below poverty. That’s over 200 million people. I mean, these numbers are just mind-boggling. Financial inclusion sounds great. A lot of people, a lot of PR has been talking about it, but really it just comes down to banking and financial sector. So can you just set the context, the macro view of what is this like? How big is the banking and financial sector?
[00:01:55.190] – Rushabh Doshi
Yeah, so let’s just take a step back. So from an investor point of view, if you take banking and financial services, it’s the largest part in the Nifty 50. It accounts for around 38% of weight in the Nifty 50. So it’s an important aspect for an investor if he’s investing through an ETF from direct equity or from a mutual fund. It’s a big sector. And you know what I like about it is that it’s well regulated. So everything is organized. We have many industries where there’s unorganized or organized, but in this sector, everything is organized and well regulated. And as you just said, we are under-penetrated. So if we take mortgages, which is a big part of banking, in developed countries, it’s around 80%. In USA is around 52%. In India, it’s just around 10% to 15%. So there’s a lot of room there left for growth if we take household leverage to GDP even there, India is almost at the lower quarter, where we are just around 19%. And certain developed countries have even cost 110%. So there’s a long way to go in this industry. And as you said, there’s a lot of need. And at the end of the day, what I believe is that you take whichever industry, banking is the backbone for that industry, and it drives economics and it actually magnifies gains or whatever could happen in ten years. Banking and easy access to credit makes it possible to do that journey in just five years.
[00:03:37.430] – Darshan Doshi
So another data point is around the Pandemic. Just before the Pandemic, there were a lot of reports around India touching $5 trillion economy by 2025. The updated same research report says that India is likely to now become a $5 trillion economy by 2027. Now, what I find is whether it’s 2025, 2027 or 2030, I think it doesn’t matter very much because we are almost talking about a 30 or 40% growth in our total GDP economic activity, which means there is money to be made. And if there is a bigger pie, then everybody who’s living in it gets a bigger piece of the pie. And so it’s natural flow of money going down to the masses. And those numbers are scary. The numbers that you shared right. Are very scary. I wish there was a way for us to put a nitro boost on this. But let’s take one step back. Let’s go into the history of banking. So what is the history of banking, really?
[00:04:43.090] – Rushabh Doshi
So it all started in Italy. So what used to happen, like traders used to come with their ships to trade, but at that time, the problem was that they had different currencies. So each trader then had to stock seven to eight different currencies and coins. So near the ports, these guys used to sit on benches. So in Italy, it used to be called Banco. And that time they realized that some institutions can handle this problem and make currency transactions much easier. So this is where the journey started, and that’s how we got the term banking.
[00:05:17.700] – Darshan Doshi
Brilliant. I did not know that. There’s another person whose online course I’m taking. Her name is Preethi Kasireddy, and she’s a big crypto nerd. And what she does is she’s broken down into how currencies came into existence. Right from early ages till the last 200, 300 years, how the US banking came into the picture, and what is cryptocurrency actually trying to solve, right? So whether or not you follow bitcoin, ethereum, whether you believe it or not, I think that’s a really great course which just kind of helps us understand the origins of banking and currencies. All right, we understand this is a big problem or a big opportunity, the way you want to look at it in India. But help me understand and simplify investing. We are trying to simplify investing at Swatantra. What is banking sector really made up of? How does it work? Where is the money to be made? How does lending work and who gets what? Can you just break it down and simplify it for us?
[00:06:28.430] – Rushabh Doshi
So my understanding is a bit different. So I look at banking. According to me, the banking sector is, at the end of the day, a commodity business. So it might sound funny or different in the first look, but that’s just what makes a commodity business successful, like the big oil companies or steel companies. The first thing is scale. They need massive scale such that their fixed costs remain very low as a percentage of the business and the second one is they have to be the lowest cost producer of whatever they are producing. So in banking, if we look at the big banks which have globally or in India, like HDFC or SBI, they have massive scale and they are able to leverage that scale and hence they are successful. And the second thing is that these guys have access to the lowest cost of funds. So for SBI, the cost of funds is something between 3-3.5%. For HDFC bank is near about 4%. So you know, this is the reason why big banks can easily make a lot of money and this is the same reason why small banks or smaller NBFCs struggle a lot in their initial 5-10 years of this business.
[00:07:41.410] – Darshan Doshi
So that is good. All right one of the things that I worked at Reliance Industries for a couple of years and this was around when Jio was being launched and Reliance was able to raise just over 20 odd billion dollars and their cost of capital was a few percentage points higher than what you mentioned and that’s because Reliance has a better than sovereign rating as a private company. I think it’s the only company that has a better than sovereign rating in India. Which means India may default, but Reliance will not default and I find that tremendously fascinating and what I hear from you is the possibility or likelihood that an SBI or an HDFC would fail is minimal and therefore they are able to command that scale and that cost of capital at a very low percentage point and then lend it. But that is one part of them raising that money at whatever rate you’ve mentioned. What about lending? How do they make money?
[00:08:47.980] – Rushabh Doshi
Yeah, so let’s come to the basics. Let’s say suppose I want to lend 100 crores so I’ll set up maybe a small institution and I’ll find people to lend so let’s say I lend at 8%, then I have costs which I have to pay and at the end of the day if I lend at 8% I just make 2% then what would I think? That if I kept my same 100 crores in the bank FD I would have earned higher. So how banking improved? Or what is the right way is that you need to leverage? So if I have 100 crores, I need to borrow, let’s say 700 crores and then I’ll have a leverage ratio debt to equity of 7:1. So I’ll be levered seven times and now then I’ll lend 800 crores and now if I make the same 2% which we assumed in the first case, I’ll make 2% on 800 crores I’ll pay some interest on the 700 which I borrowed. Let’s say I pay it at 6% but my cost would be same, which would be fixed in nature. So I’ll end up making 2% on 800. So my return on equity, which is the 100 crores I have put now, it would be 16%. So if you just take a step back and look what lending does, it magnifies your returns. So earlier we used to make 2%, but with the eight times leverage, now we are making 16% return on equity, which is a respectable number and which is what an investor should look at. Good NBFCs like Bajaj Finance makes more than 20-21% and certain NBFCs like SBI cards make an ROI of 30%. So this is where the magic works. But leverage is a double edge sword. If you use it properly, you make killing while making a return. But if you don’t use it properly, you cut yourself.
[00:10:45.230] – Darshan Doshi
Yeah, I think we saw that in 2008 crisis, right? I think the housing crisis that took place, we saw what happened. Even in 2020, I think even if you take a look at the real estate or the local shops, restaurants that you might have seen in any place that you live in, any city that you live in, a lot of hands have changed of the owners of these restaurant or cafes because of debt and unable to service that debt due to pandemic in 2020 and 2021. I think we’ve seen quite a lot of the downside of debt. One interesting point I was reading while I was researching the banking and financial sector was that India traditionally is the interest rate to growth rate differential has always been positive. In a sense it is a norm and not an exception that our growth rate is higher than the interest rate. And so maybe some thoughts around because you talked about debt. How are you thinking about it from the point of view of an HDFC or a Bajaj to be able to deliver good returns over a 10-year, 20 or 30 years? Any stats around historical performances of such companies?
[00:12:09.260] – Rushabh Doshi
Yeah, so like you mentioned, two of the best companies in the respective sector. So if you take HDFC Bank, they have been able to deliver 20% continuous growth in AUM revenue. And since a very long time, at least even since I’ve been in this industry, I’ve been seeing that 20% is there every time. If you take Bajaj Finance, they’ve been able to do 30-32% since they decided to they wanted to focus on the financial NBFC of their corporate also. So they’ve been doing quite well. Just what I like, like Sanjiv Bajaj, who heads Bajaj Finance, this thought process about lending is very different to what all the other people or what we think. So when he says when I give a Rs 100 loan and let’s say I charge 20% and then if we break it into Rs 10 installments in each month for one year. He says that my profit is in the last two months but when we see or when the things which you mentioned about housing finance companies going busted. What they focused was on lending very aggressively and they used to show book profits. But these profits are not actually there because after a certain time all these loans went back and they had to be written off. So in this business it’s very easy to give loan, if you just stand and just say that I’m giving money, return it to me, everyone will put a line there and there’d be many borrowers. But collecting money is the most important and difficult part of this industry.
[00:13:49.170] – Darshan Doshi
Rushabh, you’ve kind of covered a little bit on the origins of the currency, the banking sector, the trends. Now let’s get into the details of banks versus NBFCs, the non-banking financial companies, right? And the regulation has come along the way over the last three, four years. So maybe what you can do is help me understand and just break down banks versus NBFCs, what’s really going on.
[00:14:20.000] – Rushabh Doshi
So banks are full fledged banking activities. They carry out activities across the spectrum. So right from lending to accepting deposits, doing forex transactions and all of the not so sexy part of the business, everything is carried out for them. And there are separate types of banks. In India we have universal banks which can do everything. So these are HDFC, SBI, then we have SFBs, which are small finance banks which their focus is more on Tier-II, Tier-III city needs like something like microfinance lending. So they don’t focus on big-ticket corporate loans and all. And then we have Payments Bank, so something like a Paytm payments bank, Airtel Payments Bank, whose core job is to help and build better payment products and so on. And in NBFCs there’s a wide range of NBFCs. So right, from let’s say HDFC, which is a housing finance company, their job is to focus on just pure mortgages and certain developer related loans. Then we have auto loans. So many people think auto loans has to do with passenger vehicles, but the real part of the pie in the auto books is the commercial vehicles or commercial buses and all. So this is a very big market and Chola Finance is a leader here, a Pan India player. And apart from that we have Shriram Transport and all. And then there are also a couple of Gold loan companies, Muthut, Mannapuram. So this is also actually a good business since it’s secured. So we have this. And also there are certain interesting public sector NBFCs. These are like semi or pseudo government arms of financing. So we have PFC, which is a Power Finance Corporation, REC, which is Rural Electrification Limited and even IRFC, which help in improving the infrastructure of the Indian railways. And when we look at the bottom part of the bottom tier, we have microfinance institutions whose core job is to provide unsecured loans and to people who don’t have easy access to credit or who don’t have a credit history. So actually, if you look at in banking, you have to take the entire bank. You can’t choose which business you want, but in NBFCs, as an investor, you can choose which part of the sector you want to play. If you want to play auto or even SBI cards, which is just focused on, let’s say, credit cards. And then you have Bajaj Finance, who’s majorly into consumer electronics. All your EMIs and personal loans, they are used into that.
[00:17:10.990] – Darshan Doshi
So I’m also pretty active in the startup ecosystem. And the fintech startups have got a lot of money. The first wave of it was back in 2014 and 2015, where a lot of startups in this fintech space came up, got some good traction, then it went through a bit of a trough in 2017-18, demonetization happened, and then again, there is a resurgence where there’s better growth of many fintech startups, and many of them are NBFCs. Of course, there’s a huge element of technology in it, but there’s a huge element of vertical play, like you said. So it can be sector focused, it can be personal loans, it can be consumer electronics. There are even payday loans that are being provided by companies like Early Salary. Right? So that’s good. One point that you mentioned was making available access to capital to small and medium scale businesses. So here’s another stat. According to World Bank, almost, and a recent survey by Trade India, 83% of small and medium scale businesses in India who have revenues between 5 crore to 50 crore said they don’t have access to capital, sufficient access to capital. And this is a survey done last year. In the last twelve months, the World Bank says almost all the micro, small, medium enterprises in India are facing the number one challenge for them is access to finance, access to capital. And so this is a massive, massive challenge, right? Which for me, if you flip around as an investor investing in banking and financial sector companies, this is a big opportunity because then the upside is huge. The second part of that report in the World Bank report was in India, even a small growth in infrastructure over the next three to five years, the rough analogy that was used for every 1% growth in infrastructure in India equals 2% growth in the economy of India. Now, that is massive. Again, I tried to connect it back to the $5 trillion economy that we want to do, but who’s going to do this? The MSMEs are going to do it, and the banks and the financial sector is going to help it. So now that the context is said of how much money there is to be made, as an investor, as a fund manager, what do you like about this sector? And why should you or anybody else put money in companies operating in this sector.
[00:20:14.970] – Rushabh Doshi
So at Proinvest Nirmiti, when we analyze companies, we focus a lot on something called reinvestment rate. So what it tells us, let’s say if I make 100 crore this year, how much am I able to invest for growth in the future years? So what we’ve seen that not a lot of companies can even invest 30% of that. So they either store it on their balance sheet or they pay it out as dividends or buybacks. But in banking, we’ve seen companies who can reinvest either 100% or even more than 120%. So this can drive growth in a huge way going ahead. So what happens is, if you are growing at 20%, and if you have a ROI of 20%, you don’t need to raise capital. Your growth, which you have to do through disbursement, is matched by what you make as profits. But now, if your ROI is 20%, and if you are making or if you’re growing by 35%, which is in the case of banks like AU Small Finance banks, or NBFCs, like Bajas Finance, they have to do a capital raise every three, four years. And these companies, like Bajas Finance, they always used to do a capital raise at very good valuation. So this ensured minimum capital dilution, which was very good for the existing investors. And this could help them accelerate their growth each and every year, and thereby generating a lot of money. So now let’s compare this reinvestment concept to, let’s say, real estate. Growing there is very difficult. There’s also a thing called building a book. So in bank, what you do is you have an AUM and you charge interest on that AUM. So let’s say if you have 100K in housing, you originate a loan of 100 crore in the first year. Then you keep on charging interest every month through EMI. The next year. If you want to grow by 20%, your 100 crore could have gone down to 90 crore, because people might have paid their principal back. You just need to originate 30 crore worth of loan and you get a 20% growth. But in real estate, if you sell thousand flats in the first year, you have to build 1st 1000 flats, sell them, build 200 more flats and sell them to achieve 20% growth. So it’s like running on a treadmill for these companies. It’s very difficult to go ahead. And what I’ve seen a similar concept is that many SaaS companies, they have the same method, it’s a different thing. But what they have is a subscription as a service part, where they bill you each month. And whenever a new customer is added, growth accelerates. So they don’t have to start from scratch, like licensing companies. So this is the same concept there. And as I mentioned, why I like to invest here is firstly, it’s well regulated. The bigger you are, it’s more of a responsibility of the regulator to ensure that you are functioning properly. So the too big to fail concept is very imminent here.
[00:23:29.410] – Darshan Doshi
Yeah, but give me some numbers, right? Give me some numbers in terms of returns, either by HDFC or SBI or any company that you might have researched over the last decade or two decades, or three decades, how much money have they made? Suppose I invested Rs 10,000 or a lakh of rupees in any of these companies, how much would I have made? Any rough numbers that you have.
[00:23:56.030] – Rushabh Doshi
So in the last 15 years, I guess HDFC bank has consistently since they’ve grown at 20%. Their share prices also compounded at 20%. Bajaj Finance, whenever they started to focus on the consumer business, they’ve delivered CAGR of more than 40-42%. So 42% is like your money doubles every two years. So that is the amount of wealth creation which they have done for the investment.
[00:24:25.070] – Darshan Doshi
Brilliant. So there’s lots of money to be made on an individual level. And HDFC, those who hold HDFC shares today, they tell me this has been their best or majority of their returns have come from HDFC shares in their portfolio. Compared to everything else put together versus HDFC, and HDFC still stands out. That’s a great business to be in and it can only get bigger. Let’s get into the heart of this sector and how money can be made or money can be lost. So I think first start with what else could possibly go wrong when you are investing in this sector where there is a lot of money at stake, there is a lot of regulation at stake. And while regulators are there to protect minority investors, the shareholders, not necessarily everything falls in place because not every scenario can be taken care of. So can you give a few examples where it has gone wrong from an investment standpoint in the banking and financial sector?
[00:25:33.850] – Rushabh Doshi
So what can go wrong? So if you just think of the banking business, you might wonder that it’s a foolish business. You lend, you get 9%, but if you lose, you lose everything. So in terms of pure mathematics, it doesn’t sound quite lucrative, but those are the risks. So if you don’t lend properly, you can lose everything. And it’s happened to many banks who chase growth very aggressively. This is a big issue there. And also what I think most of these mistakes have also been associated with many times, fraud. So if a promoter wants to defraud an existing company, first to defraud, they need a revenue and then they can siphon off money. But in the banking business, to defraud a company or investors, it’s very easy because all you need to do is raise deposits and then siphon of that money. So the risk in these businesses are very high. And apart from that, what I’ve seen is that the banking business globally, if anything happens, like the slippages, can be very fast and the shockwaves can be very severe. So in 2008, I remember that after Lehman went bankrupt, or when they were at the peak of everything was coming out, that they were not managing everything properly at Lehman in India, rumors started floating that ICICI Bank had some exposure to Lehman’s European accounts. So this bank almost raised a bank run. I remember that Infosys founder Narayana Murthy, he had 1000 crore deposits in ICICI bank. He moved that immediately to SBI. And in an unprecedented manner, RBI had to come out with a disclosure saying that ICICI bank has enough liquidity to manage their day to day activities. So these activities can be all these things can be very disruptive if anything goes wrong. And because of their leverage, when they are hit, they’re hit very hard. And many businesses, what I’ve seen is that, first of all, in order to compete with the big banks, you have to do something different. Why? Because you don’t have the cost of borrowing backing you. So all these small banks or microfinance institutions, they borrowed 11%, 12%. So they can’t go and lend to the Tier-I borrowers, like, let’s say, Tata Steel, and all because Tata Steel itself borrow at 6.5%. So if you’re borrowing at 10-12%, then you have to lend it at 20%. And when you lend at 20%, the risks, the risks are extremely high and you end up making a lot of mistakes. And there is where all your calculations also go for a toss. So that is why what we’ve seen is that it’s better for investors to stick with businesses which have a track record of delivering, which have access to low cost points, and which have access to high quality customers who they can lend to. So this is what we’ve seen works very well in this industry.
[00:29:00.430] – Darshan Doshi
So one of the due diligence parameters as an investor is to see the scale of the banks or the companies that are operating in this sector. Take a look at their track record and a bunch of things. Now you kind of given an overview of what could go wrong, but can you give an overview of now I’m ready. I am convinced by your story that this is where at least some of my portfolio money should go in this sector. But there are many banks. There’s HDFC, there’s Bajaj finance, there’s SBI and what not right? So how do I go about evaluating which company I should be investing in?
[00:29:48.250] – Rushabh Doshi
So the most important thing, according to me, is the track record of the guy who’s in charge of, let’s say, the bank or the NBFC. So we see that what we like is that if these guys are grounded and they know their business well, it gives an assurance to investors that they know what they’re doing, or else we’ve seen many banks or NBFCs go bust because they just aggressively chose loan growth. And what we observe is that their target audience was such that these guys are not good for that credit. And recently I just saw an interview of Deepak Parekh where he just shared his journey of how he started HDFC. So there he just told everyone that for him HDFC was not a cashcow or a way to become very rich, but for him it was more about passion and helping build the sector itself. So he just shared one thing is that we own the very small percentage of that bank. It’s in decimals and it’s very low. And he told us that when he wanted to send his or when he wanted to help his children graduate through college, he actually went on board of other companies to get some director fee and finances children’s education. So these are one or two things which make you or help you build conviction on the people who are running the show. And you don’t want actually founders like startup founders here who chase growth like ours. So recently we saw that RBI straightaway denied giving banking license to most of these companies backed by startup founders. And second things, what one should look at here is firstly the NPS. So NPS are basically assets on the book which are not earning any interest. So this as a percentage should be very small and the bank should actually make a healthy provision against the NPS. So there’s a thing called provisioning coverage ratio which is the provisions they make divided by the gross NPA. So this should be a healthy number. So for unsecured it should be somewhere between 80%, for secured loans it should be somewhere between 40% to 50%. So this shows the quality of accounting which is carried out by the management.
[00:32:33.230] – Darshan Doshi
So this is another podcast in partnership with Proinvest Nirmiti and Dasar called Swatantra. And we truly, truly believe that if every person is financially independent as a society, we can be incredibly well off and much more better than where we are today. How do you become financially independent? First is earning money and then investing that money in the right places. So this podcast series focuses on simplifying investing so that anyone can invest their money well and grow their money well. And that requires upping your knowledge but putting it to action. If you have a financial adviser you should have enough knowledge so that you can have a decent and a smart reasonable conversation with your financial adviser or your investor about your money that you are putting in to invest in. And that is all that we aspire to do is to educate to level up the finance, the personal finance and the investing knowledge at the Swatantra podcast series we will bring you a series of these podcasts where we will cover sectors companies global investment with Rushabh and Jaydeep. So stay tuned. If you want us to cover any particular topic, let us know. Just add a comment, reach out. To us. And we’ll be sure to cover this for you as well. Bye. See you soon.
