Financial services stocks: Invested in quality financial services stocks? Just stay calm to win the race -

Financial services stocks: Invested in quality financial services stocks? Just stay calm to win the race

The Indian financial services sector provides long-term investors an opportunity to benefit from three tailwinds which are unique to India:

  • Public sector lenders dominate Indian lending and continue to lose market share. As a result, in addition to banking sector credit growth being 2x of real GDP growth, private banks in India have grown at 1.75x of the banking sector credit growth since FY09, and

  • Wide dispersion in the quality of companies within the private financial services universe provides an opportunity to a select few well-capitalised private players to accelerate market share gains post a crisis.

More details are provided below on each layer of growth.

First layer of growth: the Indian banking sector grows at approximately 2x of real 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 a 2x multiplier of real GDP growth. In the three years prior to the Global Financial Crisis, India’s real GDP was growing at approximately 8%, while the Indian banking sector’s credit growth was 33%, in FY05, 32% in FY06 and 31% in FY07. It is widely believed that when an economy’s banking sector credit consistently expands at more than 3 times the real GDP growth, it eventually leads to rising NPAs at a systemic level. This heady growth of over 30% was followed by the global financial crisis and rising NPAs for the Indian banking sector.

However, since the Global Financial Crisis (GFC), banking sector credit growth has been more subdued at approximately 2x of India’s real GDP growth. The post-GFC period can be divided into two distinct phases:

  • Phase 1 (2009 to 2014): During this period, the public sector banks continued to grow at 15-20% and the funding of long-term infrastructure projects, greenfield projects, giving loans to dodgy companies continued. As a result, the credit growth was broadbased across private and public sector banks during this period.

  • Phase 2 (2014 onwards): During 2014-15 as a part of RBI’s asset quality review most public sector banks and a few private sector banks were forced to recognise additional NPAs. The recognition of these additional NPAs had a severe impact on the networth of these banks. As most PSU banks saw their Tier-1 capital being eroded, their ability to lend reduced considerably. As the capital-starved PSU banks still had 70% market share in India’s banking sector, the country’s credit growth decelerated to 8-10% during FY15-20. What made the situation worse was that the RBI’s asset quality review was followed by multiple other macro headwinds over the next few years such as demonetisation, introduction of GST, the ILFS crisis, the DHFL and the Yes Bank crises.

However, even during this period the private sector banks continued to grow their loan books at over 15%.

Indian banking sector credit growth has been 2x real GDP growth since 2008


Source: Marcellus Investment Managers, RBI; the years on the x-axis refer to financial years. Eg. 2009 is FY09

Second layer of growth: Private sector banks grow at approximately 1.75x of the banking sector’s credit growth. All PSU players have an inherent conflict on whether they should allocate capital to reward minority investors or work to achieve the social or political objectives of their majority shareholder. This dynamic of PSU players losing market share is therefore structural in nature.

While the credit growth of PSU banks was significantly impacted post 2014, private sector banks have been able to grow at 15%-20% despite the Indian Financial Services sector facing multiple macro headwinds over the past few years.

Most of the growth for private players during this period has come through market share gains from the PSU banks. During FY14 to FY20, private banks increased their market share from 24% to 40% of loans outstanding. This dynamic of market share gains is the additional multiplier on top of the GDP multiplier which works in favour of private sector banks.

Credit growth of private sector banks is ~1.75x of banking sector credit growth


Source: Marcellus Investment Managers, RBI; the years on the x-axis refer to financial years. Eg. 2009 is FY09

Third layer of growth: A select few players are able to benefit from this unique opportunity in India’s financial services sector and grow profits consistently.

In any sector, the ability to grow profits consistently for any company is dependent on:

  • Reinvestment rate: Unlike some of the western countries where there are no avenues of reinvesting profits, as discussed in the earlier section, the Indian financial services sector is growing rapidly and provides a long runway for growth. This results in Indian lenders having a high reinvestment rate. As seen in table below, the likes of , Kotak Bank and Bajaj Finance consistently reinvest over 80% of their earnings back into the business.

Despite the reinvestment rate of these high quality lenders being in excess of 80% for more than a decade, none of them have reached a market share of even 10% yet in India’s lending industry. Bajaj Finance for instance has a market share of less than 1.5%.

  • Raise leverage upon the reinvested capital: Not only do lenders reinvest more than 80% of their earnings back into the business, but the reinvested capital is further used to raise debt which is also deployed in the business. This amplifies the impact of a lender’s reinvestment rate. The illustration below highlights that for a bank or NBFC which is leveraged 8x, an 80% reinvestment rate implies a reinvestment rate of 720%.

8x leverage helps amplify the capital employed by a high quality lender


Source: Marcellus Investment Managers.

  • Generating consistent return on assets: The ability of lenders to reinvest 8 to 9 times more capital than a conventional company works wonders for those lenders who are consistently able to generate sustainable return on assets (RoA) while it destroys lenders which are unable to consistently generate return on assets.

Given that any rapidly growing sector attracts competition either from new entrants or by way of aggressive pricing from existing players, India’s lending sector has been no different. India has thousands of NBFCs and a long list of banks. However, only a select few players such as HDFC Bank, Kotak Bank and Bajaj Finance have been able to build competitive advantages to generate consistent RoAs leading to rapid profit growth.

High reinvestment rate along with stable return on assets for top quality lenders


Source: Marcellus Investment Managers, company data; Reinvestment rate is calculated as (1 – dividend payout ratio); the years on the x-axis refer to financial years. Eg. 2010 is FY10

High reinvestment rate and stable RoAs result in consistent profit growth


Marcellus Investment Managers, company data; the years on the x-axis refer to financial years. Eg. 2006 is FY06
While there are sectors other than financial services which have historically delivered strong growth, such strong growth in other sectors has been either cyclical (e.g. infrastructure) or the benefits of strong growth have been passed on to the end consumer (e.g. airlines, real estate and telecom) as the companies in those sectors have been unable to create any competitive advantages. What makes the Indian financial services sector unique is the consistent growth for private sector players and the ability of a select few players to generate return on equity above cost of equity.

Given the favourable sector dynamics and the fragmented nature of the industry, investors do not need to chase growth by investing in low quality lenders as growth expectations of investors will be taken care by strong sectoral growth itself.

Investing in lenders which have clean accounting, adequate capital Tier 1 buffers and the ability to generate return on equity above cost of equity because of their competitive advantage gives you a high-quality portfolio which can absorb downside risk and capture the unique upside opportunity that the Indian financial services sector provides.

(Tej Shah also contributed to this writeup. HDFC Bank, and Bajaj Finance are a part of many Marcellus portfolios. Mukherjea and Shah are part of the investment team at Marcellus Investment Managers (

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