Introducing Kings of Capital – our financial sector PMS

Over the past decade, India’s Financial Services sector has been hammered by demonetisation, the ILFS crisis, Yes Bank’s collapse and now the Covid crisis putting extreme pressure on weak lenders. However, history shows that investing in high quality financial stocks during a crisis proves to be highly rewarding. The key objective of our “Kings of Capital” strategy is to own a portfolio of 10 to 14 high quality Financial companies (banks, NBFCs, life insurers, general insurers, asset managers, brokers) that have good corporate governance, prudent capital allocation and high barriers to entry

“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised ” – Warren Buffett

The case for investing in high quality financial stocks during a crisis
As seen in Exhibit 1 below, investing in financial stocks during a crisis delivers not only outsized returns in relative terms but also in absolute terms. For example, if you had invested in the Bank Nifty when it bottomed out during the Lehman crisis (on 9^th March, 2009), your five year compounded return would have been 28%. Even if you had invested three months PRIOR to the bottom, your five year return would still have been a very respectable 21%. The reason that this happens is that investors enjoy the following tailwinds by investing in high quality Financial Services stocks during a crisis:

Acceleration of growth of high-quality lenders due to market share gains post the crisis (as the weaker lenders fade away);
Normalisation of NPAs and system level credit growth once the crisis ends; and
Normalisation of P/E multiples as economic growth, credit growth and NPAs normalise.

The foundations of India’s economic and financial recovery are in place
As highlighted in our 22^nd March blog (click here to read), four times in the last 40 years, a US recession alongside falling US bond yields and falling oil prices has been followed by a strong economic recovery in India. In fact, India has never witnessed an economic recovery without a US recession preceding it! Now, all three conditions for an Indian economic recovery – a US recession, smashed crude prices and falling US Government bond yields are – in place. The Kings of Capital portfolio is a leveraged play on the Indian economy and hence should benefit the most from the economic recovery in India.

A long-term view of Indian credit cycles also suggests something similar – a few years of high loan book growth, low NPAs and economic boom are typically followed by low credit growth, high NPAs and recessionary fears. Good quality banks and NBFCs manoeuvre through these economic and financial cycles with razor-sharp focus on capital allocation, execution and underwriting. These premier banks and NBFCs they do not get swayed by the common emotions of greed and fear and this is the primary reason for their market leading position

High quality lenders tend to gain market share post a crisis
HDFC Ltd. during the crisis of the late 1990s as well as HDFC Bank post the 2008-09 global financial crisis, went through a period of recovery and then rapid market share gains. Similarly, once the COVID-19 crisis is over, competition will reduce for well-funded lenders. This is because the well-funded lenders are able to absorb a sharp rise in NPAs and are therefore are amongst the ‘last men/women standing’ in the lending industry. As the crisis abates, the stronger lenders benefit as:

Their loan book growth accelerates whilst being funded by their high-quality liabilities franchise;
Their NPA ratios fall materially; and
Their net interest margins expand as these lenders are able to pick and choose borrowers.

In the table below we have shown all three effects playing out for HDFC Ltd. at the turn of the century and for HDFC Bank after the Lehman crisis

How has the Kings of Capital portfolio been constructed?
The three tenets for selecting stocks in Kings of Capital remain the same as in our previous two strategies – Consistent Compounders and Little Champs:

Clean accounting and good corporate governance;
Historical evidence of prudent capital allocation; and
High barriers to entry so that companies are able to sustainably generate return on capital higher than cost of capital.
Given the inherently leveraged business models of Financial Services companies, the importance of each of these traits is further amplified and therefore we believe we can put our skills around forensic accounting and understanding barriers to entry to good use to create a portfolio of high quality Financial Services stocks. Keeping this in mind, we have created a portfolio of high-quality lenders, general insurers, life insurers, asset managers and brokers. Exhibit 6 below explains the process we have followed for selecting stocks in the Kings of Capital portfolio.

How volatile will a Financial Services focused fund be?
The Kings of Capital portfolio will consist of lenders as well as non-lenders (life insurers, general insurers, asset managers and brokers). The non-lenders in the portfolio not only give sustainable growth because of the large structural opportunity that they can capture over the next decade and also reduce the volatility in the portfolio. Creating a portfolio like this wouldn’t have been possible say in 2017 because a large part of India’s non-lending ecosystem wasn’t listed until a couple of years ago.

Despite the fact that the past two years have seen the ILFS crisis, Yes Bank collapse and the Covid-19 crisis, the Kings of Capital portfolio would have delivered a 12% IRR return since April 2018 vs. a 5% return for the Nifty and a negative 2% return for the Bank Nifty. Furthermore, the Kings of Capital portfolio has delivered these superior returns with significantly better Sharpe Ratios due to our focus on clean accounting and sustainable earnings growth as demonstrated in the table below

Please click here for further details on the Kings of Capital strategy and please click here

for the recording of the webinar launching this strategy.

Regards
Team Marcellus

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