For any company to consistently, it needs two key ingredients – a) high return on equity (RoE) and b) a high reinvestment rate. However, this combination is more difficult to achieve for lenders (banks, NBFCs, and insurance firms) than for companies in any other sector.
In a recent newsletter named - 'Three Different Routes to Compounding Heaven', investment firm Marcellus explains this. Lenders are leveraged businesses and have a unique business model very different from other non-financial companies and this makes it difficult to compare metrics of lenders with other companies, it said.
It further noted that if a company is reinvesting large amounts of capital, sooner rather than later, ROE tends to fall as the firm either encounters rising competition or runs out of addressable market space.
"For instance, for most non-financial companies, the earnings growth is lower than the return on capital employed as their reinvestment rate is usually less than 100 percent. On the other hand, the earnings growth of quality lenders is usually higher than their return on equity due to the ability of these firms to deploy large sums of capital profitably. Hence, the reinvestment rate of lenders cannot be simply calculated as 100% minus the dividend payout ratio," explained Marcellus. It is interesting to note that quality lenders in India are able to generate high RoEs along with high reinvestment rates, it added.
As per the newsletter, the reasons for higher RoEs for lenders along with high reinvestment rates are as follows:
1) Banking sector growth supported by India’s nominal GDP growth: As India is still a developing economy with low credit penetration, not only does India’s GDP grow at a relatively healthy rate but credit growth is also higher than the nominal GDP growth which itself is 10-12 percent per annum, noted Marcellus.
2) Competitive dynamics: Marcellus explains that in India public sector (PSU) banks still have 60 percent of the market share of the banking sector in India. However, since PSU players have an inherent conflict regarding whether they should allocate capital to reward minority investors or work to achieve the social or political objectives of their majority shareholder which is the Government; the private banks are able to gain market share year after year, it stated.
3) Quality lenders still have a long runway for growth: Despite PSU banks continuing to lose market share, some of the quality lenders in India still have a low single-digit market share in advances and deposits, noted Marcellus.
Given the above dynamics, the reinvestment rate of even India’s largest private sector bank, HDFC Bank, has been 96 percent over the last 5 years as compared to the median reinvestment rate for the top 5 banks listed in the US was at 68 percent during CY17-21, informed the investment firm.
Another major positive for the lenders in India, as per Marcellus, is that over the last 10 years, quality Indian lenders have reported growth in BVPS (book value per share), which is very difficult.
"These lenders have been able to raise capital at high P/B multiples because of their proven ability to deploy large amounts of capital profitably. Had these lenders raised capital at P/B multiples closer to 1, growing BVPS faster than RoE would not have been possible," the newsletter said. In the long run, share prices for financial services companies tend to follow their BVPS growth, it added.
In this context, Marcellus pointed out that HDFC Bank, Kotak Bank and Bajaj Finance have been able to grow their book value per share at a CAGR of 21 percent, 19 percent and 31 percent respectively over the past 10 years aided by reinvestment rates in excess of 100 percent.
However, it noted that as the ability to raise capital which is BVPS accretive is linked to the ability to consistently generate high RoEs, there are only a select few lenders (the 3 mentioned above) who have been able to do this consistently over a long period of time.
Different approaches followed by quality lenders to compound BVPS:
HDFC Bank: HDFC Bank has consistently paid dividends using 20 percent of its profits over the last decade. However, the bank raised capital twice during the last 10 years. Given these large capital issuances at high P/B multiples and stable RoEs (at 18 percent), the bank was able to post 21 percent BVPS compounding, noted Marcellus.
Kotak Bank: Like HDFC Bank, Kotak bank also compounded its BVPS at a healthy rate of 19 percent CAGR, however, the bank adopted a different route. Over the last 10 years, Kotak Bank paid negligible dividends but raised large amounts of equity capital – the bank has raised capital 4 times (once for the ING merger and thrice otherwise) – at high P/B multiples, Marcellus informed.
Bajaj Finance: Bajaj Finance has paid out 12 percent of its profits as dividends over the last 10 years. Bajaj Finance was the fastest-growing lender over the last 10 years and also the lender with the highest RoE (around 20 percent). It was thus able to compound its BVPS at a rate of 31 percent over the past 10 years.
BVPS and RoE
The investment firm explained that companies that can consistently generate ROE much higher than the cost of equity, tend to trade at prices much higher than their BVPS. As these companies reinvest profits back in the business and raise equity capital to support growth, BVPS compounds faster, it added.
This creates a virtuous cycle where strong lenders continue to generate high RoEs, growth and raise equity at prices much higher than BVPS, leading to sustainable long-term wealth creation for the shareholders. Availability of capital for these lenders also allows them to gain disproportionately higher market share, it further stated.
