Investors are being urged to exercise greater caution when considering investments in India’s Non-Banking Financial Companies (NBFCs). While the sector has experienced significant growth, a narrowing earnings premium compared to traditional banks, coupled with margin risks and increasing competition, is prompting a shift towards more selective investment strategies. This comes as digital lending platforms, backed by major players like Airtel and Jio, begin to reshape the financial landscape.
The call for increased selectivity comes from Viral Shah, of IIFL Capital, who has been advising clients to reassess their NBFC holdings. Shah points to three key factors driving this change. First, valuations for many NBFCs are now approaching long-term averages, and in some cases, are considered “rich,” despite strong earnings growth. Second, the historical advantage NBFCs held in terms of earnings premium over private and public sector banks is diminishing as banks themselves experience renewed growth. Finally, and perhaps most critically, margins for NBFCs are under pressure, particularly for those with lower credit ratings.
“Incrementally over the past couple of quarters, we have been recommending to clients that NBFCs now is the time to be a bit more selective,” Shah stated, as reported by the Economic Times. He explained that despite a 125 basis point reduction in interest rates, yields on non-AAA rated NBFC paper have remained stagnant for the past year and a half, creating a clear differentiation within the sector.
Margin Pressures and Funding Costs
Shah highlighted a concerning trend: while NBFCs have benefited from lower borrowing costs from banks, these gains are being offset by higher costs when borrowing from the market. This dynamic suggests that further cuts in repo rates may not translate into reduced funding costs for NBFCs, potentially leading to earnings reductions. The ability to manage these funding costs will be a key determinant of success for NBFCs moving forward.
The issue of margins is particularly acute for NBFCs dealing with borrowers who don’t have AAA credit ratings. The lack of reduction in yields for these borrowers, despite broader rate cuts, indicates a persistent risk for these institutions. This underscores the importance of focusing on NBFCs with strong credit ratings and diversified funding sources.
The Rise of Digital Lending and Competitive Landscape
The NBFC sector is also bracing for increased competition from recent entrants in the digital lending space. Companies like Bharti Airtel and Jio are entering the market alongside established players like Bajaj Finance, promising to disrupt traditional lending models. While Shah believes these new players have the potential to gain market share, particularly in digital distribution, he anticipates a gradual rollout.
“It took Jio Finance three years to reach a ₹20,000 crore loan book on the NBFC side,” Shah noted. “In the near to medium term, there is no material threat to larger players.” He suggests that larger, more diversified NBFCs are well-positioned to withstand this increased competition, possessing the scale and resources to adapt and innovate.
Focus on Diversification and Stability
Given these evolving dynamics, Shah recommends investors prioritize NBFCs that are well-diversified and possess advantages on the liability side, such as strong parentage or high credit ratings. These characteristics, he argues, will contribute to more stable and predictable earnings growth over the long term.
Valuations remain a critical consideration. While current valuations are justified by the strong growth experienced by many NBFCs, Shah anticipates potential rationalization as digital lending becomes more mainstream. However, he remains optimistic, suggesting that even with some valuation compression, investors can still expect a compound annual growth rate (CAGR) of 18-20% from larger NBFCs delivering 20-25% earnings growth.
Market Patience and Valuation Resets
Shah also addressed the issue of market patience, acknowledging that valuation resets are sometimes necessary when earnings growth slows. He used Chola Finance as an example, noting that its stock price was significantly lower a year ago but the underlying fundamentals remained strong. This illustrates the importance of focusing on long-term prospects rather than short-term fluctuations.
“If one expects steady 20-25% earnings growth and the new reality is 15%, there has to be a valuation reset,” Shah explained. “In cases of temporary blips, markets may eventually be patient, and it could be an opportunity to double down.”
The evolving landscape of the NBFC sector in India demands a more discerning approach from investors. The days of broad-based investment in the sector appear to be waning, replaced by a need for careful analysis of individual companies, their financial strength, and their ability to navigate the challenges and opportunities presented by digital disruption and changing market dynamics. The focus on long-term earnings stability, diversification, and strong liability management will be crucial for success in this increasingly competitive environment.
Looking ahead, investors will be closely watching for further developments in digital lending, regulatory changes impacting the NBFC sector, and the overall macroeconomic environment. The next key indicator will be the earnings reports released by major NBFCs in the coming months, providing a clearer picture of their performance and outlook.
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