Monday, September 16, 2013

NBFCs - the case of the Unknown Unknowables

For a long time, NBFCs in India have been talked about, from both the positive and negative points of view. Positive, because India is such a huge country where a large chunk of population is not served by the banking system. NBFCs therefore have a huge opportunity to serve this un-addressed market. Negative, because of the huge frauds happening, opaque lending practices, allegations of NPA 'management' etc etc. 
In this post, I am talking about 2 NBFCs; First Leasing Company of India Ltd and Tourism Finance Corporation of India Ltd. My objective is not to pass judgement about these companies, but to showcase why investing in NBFCs is full of unknown risks.

Some fantastically managed NBFCs like Sundaram Finance, Bajaj Finance have been huge wealth creators for investors. The case of First Leasing is, well, a bit different.
  • First Leasing Company of India Ltd was, well, the first leasing company of India! Started way back in 1973 by Mr.Farouk Irani, the company was the pioneer in corporate leasing industry. 
  • Over the period of 4 decades of its existence, the company reported good numbers, gave good dividends, had negligible NPAs and was considered as the benchmark in the field.
  • Last week, the CMP of the stock was Rs.32, with a book value of Rs.150 plus and a dividend declared of Rs.1.80, making it a dirt-cheap, attractive opportunity. 
  • There were also talks of a sell-out happening, making it even more attractive.
  • I had looked into this company earlier and the only thing I found amiss was that long term lending was being done with short term funds. This typically happens when an NBFC falls short of capital and needs funding. However, to be honest, I did not find any 'fraud' in the books, on the face of it.
On this background, it was quite shocking to read RBI's press release.

In the light of the findings of the inspection of the books of accounts and other records as on March 31, 2013 of First Leasing Company of India Ltd., 749, Anna Salai, Chennai 600002, the Reserve Bank of India has, in public interest and in exercise of the powers conferred on it by Sections 45JA and 45L of the Reserve Bank of India Act, 1934, directed that until further orders, First Leasing Company of India Ltd. shall not,
  1.  sell, transfer, create charge or mortgage or deal in any manner with its property and assets without prior written permission of the Reserve Bank of India;
  2.  declare or distribute any dividend;
  3.  transact any business; or
  4. incur any further liabilities.
Essentially, RBI has frozen the company's business altogether. This happens only when there is a system level fraudulent issue or there is severe non-adherence to laws and guidelines. Something of this sort happening to a company with a 40 year history, consistently negligible NPAs, great looking financials, great dividends is very shocking indeed. There are such a lot of things about the lending business we dont know and cant know. IMHO, this event will surely have an impact on overall NBFC valuations and the way the market perceives the sector and its companies.

Let me give you another example, that of Tourism Finance Corporation of India Ltd. This is again a listed company with a market cap of Rs.160 cr. Book value is Rs.50, CMP is Rs.20. They have also applied for a banking license recently! :-)

Have a look at this bid document. This is about a company they had lent to which went under and now they are auctioning off that company's assets to recover their dues. On page 11 of the document, details of their exposure are given, which i am reproducing here..


On a loan given of Rs.3.35 cr, there was interest accrued of Rs.109 cr!!! How much of this has been accounted for as income in their books is not known, but the sheer size of one of their loans with respect to the company's overall size is mind boggling. If a large write-off like this one happens, the book-value itself would be massively hit and the stock would no longer look cheap.

Learnings from all of the above:
  • The NBFC business is structurally a risky business, where a fine balance has to be maintained between growth and quality of assets. Few companies which sacrifice quality to show growth and adopt aggressive accounting do great for some time, until the bad quality loans catch up with them and then comes a huge huge write-off.
  • It is extremely critical to understand what the business is. Merely going by its financials and book-value (which a lot of investors do) will not help. Book value is an accounting concept and can be bloated very easily. If one does not understand how the business is operated, better to not get into it at all. 
  • It is also extremely critical to understand the laws governing the NBFCs. The capital and provisioning requirements of the RBI can change the overall picture of a company very fast and one needs to have a good grasp on the same.
  • All in all, one needs to acknowledge that there are a lot of 'unknown, unknowable' aspects in the NBFC business. One should therefore not rely 100% on the numbers for taking investment decisions. It is much better to go with a proven management, which is fully transparent on all the aspects of the business and is in a business which one can understand and identify with properly. Good knowledge of accounting and ability to dissect the financial statements is also essential. If investing is risky, investing in NBFCs is, ummm, more risky!
Please do greater due diligence while investing in NBFCs. There are many aspects of the business which we cannot understand by studying the financials alone.

Cheers and happy investing!!!


Disclaimer(s)!!
1) All the posts on this blog, including this one, are for educational and discussion purposes only.
2) I post articles on individual stocks as well as varied topics like behavioural finance, industry analysis etc. None of the material posted should be regarded as advice to buy/sell any stock. My articles are not recommendations to buy/sell individual stocks, and should not be construed as any form of investment advice.
3) As a professional investor, I may have positions in stocks discussed.
4) PLEASE DO NOT TAKE BUY/SELL OR ANY INVESTMENT DECISION BASED ON ARTICLES YOU READ ON THE BLOG. These are only meant to provide information and initiate discussion. Final decision is and always should be, yours and only yours! 

17 comments:

Anonymous said...

Thank you... I have been looking at Tourism Finance as a wonderful 'cheap' company to buy. This article has just prevented me from investing huge amount in it.

Shantanu Bankar said...

Hello sir. From my perspective Shriram finance is really a good stock to invest, lately they came up with bonds, and their segregation of investement was in only various tenure g-sec when the rupee was depreciating badly. Many of my friends and relatives had invested in the same. And thanks for such a inquisitive article regarding NBFC. If time permits can u please elaborate on which NBFC's are more riskier, when we consider them public deposit accepting and non public deposit accepting. And does it impact one's invetment (from companies perspective) when they accept public deposits, since what i had known they are the costliest source of raising funds. Thanking u.

Rohit Chauhan said...

hi neeraj
add majority of the banks to this list - who knows what is in their books. only reason they will not go bankrupt is the due to govt support and rbi rules (which change based on the need of the hour)

rgds
rohit

Neeraj Marathe said...

Most welcome Anon..

Hi Shantanu,
In my view, NBFCs which have transparent disclosure practices and understandable business model can be considered as less risky, simply because we can know at least a bit about what they are doing.

Hi Rohit,
Well, i used to audit banks during my CA articleship, so i would agree with you! :-)

Cheers!
Neeraj

Nasir Khambatta said...

Hi Neeraj,

First Leasing was indeed a surprise (or not!)..... It belongs to the SPIC group (Muthiah) who by their own admittance need to rebuild their credibility with banks.

First Leasing has filed a case against the RBI as they would need to even obtain RBI approval for day to day expenses... which is something unprecedented.

First Lease once again proves the "myth" that Indian companies that have promoter shareholding below 30% perform extremely poorly.

Venkat said...

hello neeraj

A nice article on NBFC's. I personally feel[ completely personal opinion] that book value cannot be taken as a proper measure in case of banks and NBFC's.

Although in case of banks i am willing to take a risk. NBFC's and Pharma company stories can become dud stocks with a single regulation

Neeraj Marathe said...

Hello Venkat,
Your personal opinion happens to be my personal opinion too!
cheers!
Neeraj

Abhijeet said...

Dear Sir, Thank you for the wonderful analysis. I am of opionion that Gold loan companies are good for India in long run. Anything which drives people away from local underworld in urban areas and village sahukaar/jamindar is fine with me though they should fix their recklessnes sooner rather than later.

I had a question for you. Given eveything else being the same, what weightage would you give to below four parameters while valuing a company

Growth, Debt, Size, Profitablility

Please note, I am not saying these are only things we have to look at. I am asking this given everything else is same or for example if we want to shortlist the companies for futher research.

I would really appreciate your answer and thoughts on this.

Neeraj Marathe said...

Hello Abhijeet,
Very interesting question. Although there are quite a lot of moving parts involved, I will try and answer your question.
Growth is a parameter i give high importance to. If growth is absent, valuations remain depressed.
I am a bit debt averse, so majority of the companies i have invested in have been high cash-flow, low debt businesses.
I have a liking towards smaller size companies, but the size of opportunity for their products shouldnt be small. Large companies will find it harder to grow.
Profitability is of course important. But i would like profitability to be accompanied by good cash generation, otherwise it is not a lasting profitability.
So all in all, a smaller size, growing, cashflow generating company is what i would love.
Hope i made some sense!
Cheers!
Neeraj

Anonymous said...

Dear Sir,
Thanks for taking time to answer my question. I really appreciate it. It does make a lot of sense to go for companies which have less debt and espeially less debt in terms of its sales, profit and equity. I really have no clue how companies like Dish TV and Adani Power are liked by people.

I have got another question for you. Do you think a software can be created to pick stocks. A lot of things in stock picking are qualitative but a lot more are quantiative. So what would be your opinion about a software which can make a great shortlist of stocks based on quantitatives which then can be researched further manually. As of now most people just shortlist a stock based on buzz or just because it is a big company, neither of which is very scientific. Do you think such a software would provide value to the investor.

Please note I am not trying to sell you anything. I am merely curious about your opinion.

Regards,
Abhijeet

ETFGuru said...

Hello Neeraj,
Is it possible to get a better idea about the loan tenures and NPAs from the annual reports? I've seen some companies give a break-up of loans (like 0-90 days, 90-180, <1yr, 1-3 yrs, 3-5yrs, etc).
Apart from this one can also at the amount of good, doubtful, bad and restructured loans. The restructured part is always hidden or not easily seen in the reports.
These are my thoughts based on what I saw on some bank/NBFC reports, but feel free to correct me if I'm missing something.

Neeraj Marathe said...

HI ETF,
Completely agree with you. Which is why i would be more comfortable with companies which are transparent enough to disclose all this data.
cheers!
Neeraj

Anonymous said...

Thanks for the post Neeraj. In the comments you wrote "Your personal opinion happens to be my personal opinion too!" referring to BV as a measure of Intrinsic value for NBFCs.

If possible can you please explain this in the comments or write a post on this?

Cheers!

Neeraj Marathe said...

Hi Anon,
What i meant that i also agree that relying on plain book value is quite risky. One should adjust it for questionable loans/lendings, which have not yet been recognised as NPAs. For us to be able to do this, the NBFC should be very transparent in its reporting.
Which again leads to the same conclusion; stick with NBFCs whose business is understandable and whose mgmt is as transparent as possible.
cheers!
Neeraj

Anonymous said...

A criminal complaint has been presented before the Upper Chief Judicial Magistrate No.3, Jodhpur pursuant to which an F.I.R. has been registered with P.S. Mahamandir, Jodhpur bearing No. 580 dated 11.11.2013 against Dr. A.C.Muthiah, Chairman First Leasing Company of India Ltd. Chennai, Farouk Merwani Irani, Managing Director, Maharaja Jai Singh, Ex Director and Chairman Audit Committee and others including D.R. Dogra, Managing Director of Credit Analysis and Research Limited (CARE), its Deputy Managing Director Rajesh Mokashi, Brick Works Rating India Pvt. Ltd. And its Vice President Business Development K.C.Holla, partners of statutory auditors M/s Sarthy & Balu namely N.R.Sridharan and V. Balasubramanium and internal Auditors M/s M.K. Dandekar & Co. and its partners all related to First Leasing Company of India Ltd. as credit rating agencies, auditors etc. The F.I.R. has been filed under Section 420, 406, 467, 468, 471, 477A & 120 B of IPC read with Section 68, 217, 292 and 628 of Companies Act.

Pranav Pratap Singh said...

Hi Neeraj,
Thanks for another great article!

Sometimes I get confused between quality and possible hidden value. For example, Gruh Finance and CanFin Homes are in same business. Broadly similar financials and size of operations. Major differences that I could find was that Can Fin lends at lower interest rate (has lower N I Margins). More importantly, it is owned by Canara Bank, so we do not know about the continuity in management quality. However, it has been growing at 30% CAGR and is available at PE of 5 while Gruh Finance is trading at PE of 27.

I was evaluating cheap CanFin by benchmarking it with best in business Gruh Finance. But, then it seems to me that Gruh itself should give returns of over 15% for next 10 years. I also feel that I can take a call on the opportunity in the housing finance to under-banked population and divide investment in both of them.

What would be your take in this kind of a situation?

~Thanks

Neeraj Marathe said...

Hi Pranav,
While i have never been invested in Gruh (unfortunately!), i greatly admire the company for their transparency, systems and growth.
I hvnt looked into CanFin as such, so cant comment much on it..
As a thumb rule, in NBFCs, the higher the transparency, the better it is for us investors.
cheers!
Neeraj