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Indian Financials: A compounding miracle hiding in plain sight

In this newsletter we illustrate why investing in Indian Financial Services stocks is highly rewarding for long term investors not only in terms of absolute returns but also in terms of risk adjusted returns. The data over the past two decades suggests that: (i) the Bank Nifty has delivered far higher absolute returns than the Nifty (23% vs 14%); (ii) Investors in Financial Services stocks are more than compensated for higher volatility as the Bank Nifty has delivered over 60% higher returns per unit of risk (Sharpe Ratio of the Bank Nifty over the past two decades is 0.45 versus 0.27 for the Nifty); (iii) high quality Financial Services stocks have delivered better risk adjusted returns than high quality non-Financial stocks across all time periods; and (iv) high quality Financial Services stocks such as HDFC Bank and Kotak Bank have delivered positive returns in one out of every two market crashes even when the Bank Nifty has delivered negative returns.

Performance update of live fund

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 skills and high barriers to entry. By owning these high-quality financial companies, we intend to benefit from the consolidation in the lending sector and the financialization of household savings over the next decade. The latest performance of our PMS is shown in the chart below.

Under the TWRR method of calculating portfolio performance the initial performance looks optically lower in an upward trending market because of large inflows on a relatively small AUM. As on 17th Nov, the first customer of the Kings of Capital PMS had generated returns of 23.6% vs 32.0% for the Bank Nifty since inception.

At Marcellus we don’t believe in timing the market and hence deploy the money into our strategies as soon as the investor transfers the funds to us. However, we do recognize the emotional aspect of loss aversion in the short term and have launched a STP (Systematic Transfer Plan) plan using which clients can stagger their investment in tranches spread over 5 months. For more details please refer to our FAQs here.

The most frequently asked question that we have been asked since we launched the Kings of Capital PMS earlier in July this year is “Why invest in a portfolio which invests only in the Indian Financial Services sector?”  or “Won’t a portfolio of only Financial Services companies be far more volatile than other portfolios?” We try and answer both questions in this newsletter.

Busting some myths around India’s Financial Services sector

  • Bank Nifty has outperformed the Nifty by a massive 9% per annum over the past twenty years: As illustrated in Exhibit 2 above, over the past twenty years the Bank Nifty has outperformed the Nifty by a massive 9% CAGR. We have calculated this return on a daily rolling 1-year period basis so as to remove any bias due to beginning and ending of the period values. However, even if we were to calculate the returns on a CAGR basis, the Bank Nifty has delivered a 16% CAGR versus a 10% CAGR for the Nifty during the same period. The results are similar or even more favourable for the Bank Nifty if we were to take 3 year or 5 year rolling returns.
  • Risk adjusted returns of the Bank Nifty are over 60% higher than the Nifty: Many investors believe that investing in Financial Services stocks is riskier than investing in other sectors. As shown in Exhibit 2, the Sharpe Ratio of the Bank Nifty over the Mar, 2000 to Sep, 2020 period is 0.45 versus 0.27 for the Nifty i.e. the Bank Nifty has delivered over 60% higher returns per unit of risk taken.
  • The real volatility of Financial stocks is not very different from the volatility of the broader index: A drawback of the standard deviation calculation is that it gives an equal weight to downside and upside volatility. To illustrate this by way of an example, let’s compare the standard deviation of stock A and stock B below. As illustrated in Exhibit 3 below, Stock A has a standard deviation almost twice that of stock B because standard deviation penalizes downside and upside volatility equally. To overcome this drawback, we calculate the downside standard deviation which ignores the ‘good volatility’ and instead focuses only on the downside returns. As a result, the downside deviation of Stock A and Stock B is similar.

Applying the same principle to compare the volatility of the Bank Nifty with the Nifty, we see that while the standard deviation of the Bank Nifty is higher than the Nifty, their downside deviation is similar. In addition to this, as illustrated in Exhibit 2 above, the number of quarters where the Bank Nifty has delivered negative returns are lower than the Nifty and the number of times the Bank Nifty has delivered three consecutive quarters of negative returns is less than half that of the Nifty.
  • The Bank Nifty recovers from market crashes sooner than the Nifty: While public memory is short and during the Covid-19 crisis, the broader markets have recovered more quickly than the Bank Nifty, over the past two decades whenever the Bank Nifty has seen a drawdown of 10% or greater in a month, it has on average taken 10 months to recover versus 14 months for the Nifty.

High-quality lenders have historically always delivered better risk adjusted returns than high quality non-Financial companies

In the preceding section we saw that the Bank Nifty outperforms the broader index across most parameters. We arrive at a similar conclusion when we compare the performance of high-quality Financial companies with high quality non-Financial companies.

To compare returns of high-quality Financial companies with high-quality non-Financial companies, we created a portfolio of non-Financial companies which have delivered >10% revenue growth and >15% ROCE in each of the preceding 10 years and compared it to lenders which generated >15% loan book growth and >15% RoE in each of the preceding 10 years. We created 10 such portfolios from FY00 to FY10 and compared the returns and standard deviation for the financial companies and non-Financial companies in these portfolios over the next 10 years.

For example, the portfolio created in FY01, would consist of financial companies which generated >15% loan book growth and >15% RoE every year from FY1991 – FY2000 and non-Financial companies that delivered >10% revenue growth and >15% ROCE every year from FY1991 – FY2000. The returns and standard deviations of these financial and non-Financial companies were then compared over the next decade i.e. FY2001 to FY2010. Similarly, the portfolio for FY02 was created based on the financials of the preceding 10 years and the returns of the financial and non-Financial companies in the portfolio over the next 10 years were compared. This exercise was replicated till we got 11 portfolios with the returns of the first portfolio (denoted by P01) calculated over FY01 to FY10, the second portfolio (denoted by P02) returns calculated from FY02 to FY11 and so on till the eleventh portfolio (P11) whose returns were calculated from FY11 to FY20.

The conclusions from this exercise were eye-openers even for us:

  • Financial companies delivered better Sharpe Ratios than the non-Financial companies across all time periods: As illustrated in Exhibit 5 below, in each of the 11 portfolios the lenders delivered a higher Sharpe Ratio than the non-Financial companies.
  • In about two out of every three portfolios, the financial companies were less volatile than the non-Financial companies: In 7 of the 11 portfolios, the financial companies were less volatile (as measured by standard deviation) than the non-Financial companies and in 7 of the 11 portfolios the financial companies delivered a higher return than the non-Financial companies.

The Kings of Capital consists of high-quality Financial companies which are more resilient in times of stress

The Bank Nifty has delivered a negative return in 6 of the past 20 years (FY01-FY20) whereas the Nifty has delivered negative returns in 7 years. Most investors believe that they can time their entry and exit in stocks by predicting the movement of the general market. However, as illustrated in Exhibit 6 even those investors who would have predicted a market crash correctly and thereby exited their investment in HDFC Bank or Kotak Bank would have been wrong 50% of the time over the past two decades. In 3 of the 6 years where the Bank Nifty has delivered negative returns over the past two decades, HDFC Bank and Kotak Bank have delivered positive returns. So why are the stocks which are a part of our Kings of Capital portfolio so much more resilient?

Earnings growth offsets P/E multiple de-rating for Kings of Capital stocks: Share prices are driven by two factors – change in P/E multiples and change in earnings. Because Kings of Capital stocks grow earnings at 20%-25% on a consistent basis, their earnings growth more than offsets the P/E de rating during a stock market crash as illustrated in Exhibit 7 below in the case of HDFC Bank.

P/E multiple does not de-rate for Kings of Capital stocks even during market crashes: The other reason that Kings of Capital stocks outperform is because their P/E multiple does not de-rate even during a market crash. For example, Kotak Mahindra Bank’s P/E multiple did not de-rate in FY02, F12 and FY16 despite a double-digit de-rating of Bank Nifty’s P/E multiple.

Investment implications: By investing in a portfolio of high-quality Financial companies, the Kings of Capital portfolio benefits from three tailwinds:

  • Outperformance of the Financial Services sector: Bank Nifty as an index outperforms the Nifty by a wide margin when it comes to absolute returns as well as risk adjusted returns. Because the Kings of Capital portfolio invests in Financial companies, it benefits from this outperformance at a sector level.
  • Downside protection by way of stock selection: In addition to this outperformance at an index level, the Kings of Capital portfolio invests in a small subset of high quality Financial Services companies which consistently grow their earnings at 20%-25% and are therefore able to more than offset the P/E derating during a market crash. High quality Financial Services companies such as HDFC Bank and Kotak Bank have delivered positive returns during one out of every two market crashes. Our backtest results show that these high-quality Financial Services companies also outperform high quality non-Financial companies across all time periods.
  • Lower volatility by investing in non-lending Financials: The Kings of Capital portfolio also invests in Financial non-lenders such as life insurers, general insurers, asset managers and brokers. Because these businesses are either completely unleveraged or not as leveraged as lending businesses, this further reduces the volatility of the portfolio.

These 3 factors make high quality Financial Services stocks a must have for all investors looking to compound their wealth over the long term.

Note: HDFC Bank and Kotak Bank are a part of most Marcellus’ portfolios.
Regards
Team Marcellus

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