EDIT-3/8/2017/ We closed all our positions in Microfinance stocks in May-June 2017 due to ever increasing political interference and anarchy in rural India with cases of political  goons causing attacks on MFI collection agents, ever increasing demands of loan waivers and tragic loss of life and rioting in state of MP in June this year. However similar investment rationale has worked well for us in other NBFC stocks in housing finance & consumer finance sectors.

Unedited original post below-

The micro-finance sector has caught the fancy of stock market investors in the last few months since the successful listing of Ujjivan and Equitas. The IPOs saw eye-popping subscription levels and the stocks have continued to hit fresh highs regularly ever since.Along with the newly listed names, a handful of  NBFCs about whom no one cared for years have suddenly started going up as well

The sharp up-move has also created its fair share of doubters and naysayers who keep predicting doomsday for these stocks and the sector. How can a stock keep growing at 50-60% when economy is growing in single digits? How do they have NPAs of under 1%  when banks have bad loans of 10% and above? Why should some of these stocks trade at 8-10X times of their book value when many banks are trading at a fraction of their book value?

Now let me address above questions one at a time.

Growth Prospects- 

India remains an under-banked country but we are  now making giant strides towards 100% financial inclusion under PM Modi.The most profitable financial institution- HDFC Bank is currently growing its profits at 20% CAGR and has profits of approx Rs 3200cr per quarter.  At the other side of the spectrum, most high flying micro-finance institutions (MFIs) are currently reporting quarterly profits of 50 to 100cr and are growing in excess of 50% CAGR. Hence, even when the going has been good, even after the run up of stocks, these MFIs still remain very small when compared to the giants. In a robust economy like ours, where credit growth is expected to be in the mid teens, such tiny companies can continue to grow at 2 to 3x of industry average easily. I remain confident that the 50% CAGR for micro-finance stocks will carry on for far longer than any skeptic will be willing to concede. Maybe a decade from now, one or two of these small stocks will evolve into a popular banking giant!

Asset Quality-

Bad loans are always the greatest concern for any lending company. Especially when global economy is slowing down and the developed economies like US & EU struggling to grow at even 2%.Amidst, such a slowdown, bad loans for most govt owned banks in India have risen to over 10%. So how come MFIs are still having NPAs under 1%?

The answer is simple. Though govt banks have 10% NPAs, it is not that every 10 out of 100 borrowers are in default. The bad loans are heavily concentrated among a few hundred industrialists. Even at bad loans of 10%, the number of accounts in default would be far lower than 1%. In fact  retail focused pvt banks like Yes & Indusind have maintained their NPAs  around 1% even in current times. So if good pvt banks can maintain low NPAs for the past decade, same should be possible for MFIs too, provided they maintain adequate checks and balances and do not compromise on procedures in pursuit of growth.

Valuations-

But aren’t these stocks too expensive? Haven’t they run up 100% from their current price? Why should i buy a 500 rupees stock when it listed at 200 odd just a couple of months back?

I will answer all the above questions with this one question-

Won’t you be  happy today had you bought likes of Infosys, Sun Pharma or HDFC Bank even at 10X of their IPO price and held on till today?

Now coming to mathematical aspects-

Let as assume  there is a hypothetical MFI stock XYZ, that has book value of Rs 300, EPS of Rs 40,trading at Rs 1000/share and mkt cap of Rs 5000cr, annual PAT of 200cr that can grow at 50%  CAGR. I did some calculations,  of what price can be seen by XYZ in different circumstances.

MFI FINAL

In Table 1, I calculate the  PAT, EPS , and future book value for the next 4 yrs,assuming 50% CAGR.

In table 2 &  table 3 I make  matrix forecasting the hypothetical stock price at  different P/E and P/B levels.

From tables 1& 2 we can see that at 50% CAGR, PAT, EPS & Stock Price will go 5X in 4 yrs if P/E ratio remain constant. If P/E increases, potential returns will be even higher but will be a but lower if P/E multiples contract after entry.

The values of  P/B in table 3 are meaningless as long as NPAs remain in check and growth remains steady. However if growth starts stalling or NPAs rise then P/B matrix comes to play with strong chance of stocks falling to P/B valuations similar to those of high NPA banks.

Conclusion-

So if an investor is capable to identify the right stocks which have a capable management that can continue to maintain current levels of industry growth for the next few years while maintaining asset quality, sky is the limit of potential gains.

Disclaimer- Views personal. Do not constitute any investment advise.

Disclosure-I and my family members have holdings in stocks belonging to this sector.  My views are obviously biased, because if i didn’t believe in the growth potential of these stocks, then why would I be buying stocks in this sector in the first place?