Kings of Capital Deliver Healthy Fundamentals Across Time Periods

• Even if an investor is able to enter a mediocre Financial Services business at a low valuation (1x P/B in Exhibit 5) and exit at a high valuation (3x P/B in Exhibit 5), his returns will be significantly lower (15% vs 20%) than the investor who invested in a high-quality business at a 5x P/B multiple and also exited at a 5x P/B multiple.

• Even if it so happens that at the end of 15 years, the valuation multiples of the mediocre business and high-quality business somehow converge at 3x P/B i.e. the investor who entered the high quality business at 5x P/B exits at a 40% lower valuation of 3x P/B, his IRR on the investment will still be higher than the investor who invested in the mediocre business.

• The dilution for shareholders of mediocre quality businesses will be higher than shareholders of high-quality businesses – because higher the P/B multiple, lower the dilution. Astute management teams of high-quality lenders are also able to time equity raises such that it results in a minimum dilution for their shareholders. In our blog on Uday Kotak (click here to read) we had illustrated how Kotak Bank has timed QIPs properly to ensure minimum dilution for their shareholders.

The reasons for the strong fundamental performance of KCP portfolio companies:
 
The healthy performance of KCP companies and the numbers illustrated above are just an outcome of the following common traits of KCP companies:

• Conservative underwriting: The average Gross Non Performing Assets (GNPAs) ratios of the KCP lenders over the past 3/5/10 years has been 2.7%/2.8%/2.2% vs. the banking industry average of 8.3%/9.2%/6.3%. This differential implies that the KCP lenders have had a ~70-80% better underwriting experience than the banking industry across time periods. While a large part of the NPAs of the banking system have been on the balance sheets of PSU banks, the GNPAs of private banks during the same period have also been higher than the KCP lenders at 5.1%/4.8%/3.4%. Thus, KCP lenders have seen the asset quality differential even versus the private players only increase over time.

• Focus on segments with deep expertise and measured experimentation in new segments: Apart from the larger banks, specialized lenders in the KCP portfolio such as AU, Chola or Aavas have focused on the segments where they have developed a deep expertise in understanding the customer, underwriting and collections. These lenders operate in markets which are large enough for them to continue growing for many years and have prudently not indulged in unnecessary diversification and have therefore been able to avoid any asset quality accidents. Even HDFC Bank and Kotak Bank stayed away from infrastructure financing during 2004-13 while many other large banks were aggressively growing their loan book in the segment. Any experiments in new segments by KCP lenders such as HDFC Banks’ foray into retail lending is generally done through small pilot projects without taking substantial balance sheet risk. For eg. recently for the first time Bajaj Finance has opened branches in geographies where neither a SBI branch nor a HDFC Bank branch is present. However, these branches will initially be only deposit accepting branches with only one lending product – gold loans which are a secured, low risk product.

• Clean and able management teams: 7 of the 12 KCP portfolio companies (~60% of portfolio weight) have CEOs who have been leading the company for at least the past decade and have therefore been responsible for the healthy fundamental performance of these companies discussed earlier in the newsletter. In addition to these 7 companies, HDFC Life and HDFC Bank have CEOs who had been with the company in senior leadership roles for more than a decade before taking up the CEO role. We are therefore backing high quality management teams who have been able to deliver outstanding results in the past and have skin in the game in the form of substantial value of company ownership or ESOPs.

Changes made to Marcellus KCP Portfolio

Last month, we replaced City Union Bank with Cholamandalam Investment and Finance Company (‘Chola’). Over the past decade, Chola has emerged as one of the leading vehicle financiers with consistent growth, stable asset quality and healthy return on equity. The core business segments of Chola include vehicle finance and home equity. Over the years, Chola has diversified its loan book to include products across the vehicle financing sector and has expanded to the home equity segment which has enabled it to counter the cyclicality of the vehicle finance business. The company has gained market share in vehicle financing by growing its book at a CAGR of 20% over FY16-21 which is much higher than its peers who have grown in the mid to early teens. With a robust sourcing and collections model, Chola has been able to maintain its asset quality with GNPAs consistently below 4.0% and spreads at ~7% over the years. Chola’s Murugappa Group parentage and access to funding has helped it grow through the past few years despite the macro headwinds faced by the NBFC sector.

In addition to Chola’s sound financial performance, our decision was also prompted by the recent appointment of Vellayan Subbiah – Chola’s Managing Director during the 2010-17 period – as the Chairman of the company. Given the low business overlap with banks, the expected recovery in the CV cycle and Chola’s ability to straddle across business segments, we believe that Chola can deliver healthy earnings growth and RoEs over the next few years. While we continue to believe that City Union Bank is a well managed, conservative lender with a loyal customer base in Tamil Nadu, we expect its earnings growth to be lower than that of Chola. Given the availability of Chola as a substitute with higher earnings growth expectations, we have decided to make space for Chola by exiting from City Union Bank in the Kings of Capital portfolio.
 
All of the companies mentioned above are a part of Marcellus’ Kings of Capital Portfolio.