Quality Banks and NBFCs
There is a saying among investors for banks and other financial stocks, it goes like this, “You should never analyze a bank or finance stock based on parameters that are used to analyze the companies from other sectors“. In one of my recent learnings, I had an opportunity to learn more about Banks and NBFCs. I learned about picking a good bank or NBFC stock for investing using my common-sense combined with some key information available over the internet. I will try to share the learnings in this post, so stay tuned.
First, we need to understand the message behind the popular saying we saw above. Let me give you an example. One of the frequently used parameters to pick a good company is the debt-to-equity ratio (Please note, it is not the only parameter to decide whether the company is good to invest). The debt-to-equity ratio is used to identify good de-leveraged companies. The lower the debt-to-equity ratio of a company, the higher are the chances of generating more profits. In the case of banks and NBFCs, this debt-to-equity ratio is high, indicating that the chances of generating profits for them are low. But, banks and NBFCs make profits in a way that is different from companies in other sectors. Hence, the debt-to-equity ratio cannot be used for picking quality banks and NBFCs.
Let’s move towards our next step. In order to understand the analysis of banks and NBFC stocks, you need to understand their core business model. This is a required step, as this will help you understand the arguments I have tried to present below to pick good companies from this particular sector for long-term investing.
Before I start, allow me to issue this disclaimer that I will be explaining a very simplified short version of the business but in the real world, their operations are much more complicated.
Business Model For Banks And NBFCs
Banks offer different deposits like a savings account, current account, fixed deposit, term deposit, etc. Now, people like us park their money in these deposits. Banks try to use this money for its business. Banks keep ~20% money safe in a locker and use the balance money (~80%) to generate some profits for themselves.
- Banks collect deposits from the public, pay lower interest rates on deposits.
- Use the money from deposits to give loans, and charge higher interest.
- The difference in interest rates between loans and deposits is what banks earn.
NBFCs are not banks but run their business in a very similar manner. Unlike banks, NBFCs cannot get deposits from the public. NBFCs typically borrow money from banks or mutual funds to raise capital. Then, they lend this borrowed money to people, businesses, and so on. The difference in interest rates between borrowing and lending is what NBFCs earn.
High Risk & Low Risk Lending
There are two basic types of loans that every bank and finance company gives to make money: Secured loans and Unsecured loans.
A secured loan comes with a guarantee of partial recovery if not full for a lender. While an unsecured loan comes with little or no recovery.
In short, an unsecured loan is highly risky than a secured loan. Read more about secured loans vs unsecured loans on fundbox.com
NPA this! NPA that! What is a NPA after all?
We often read or hear this term in news, majorly associated with finance companies. In a few words, NPA or Non-Performing Asset is a loan that is not been re-paid to the lender. In such a case, the lender considers the loan agreement to be broken as the borrower of the loan is unable to pay back the loan amount. According to me, NPAs are just as good as a loss for the lender.
Finally! On Identifying Quality
Often markets test our patience in a similar way as this article. With that said, we have covered all things one should know about the business run by the banks and NBFCs. I will now discuss most of the indicators and aspects that one can use to analyze and pick quality financial companies from the banking and NBFC sector to invest in.
1. Strong in deposits
Stick to the banks that get strong deposits. Strong deposits mean a decent cushion in bad times for the bank.
2. Unsecured lending is risky business!
Banks and NBFCs doing business by lending out of proportion unsecured loans are risky to invest. The more the unsecured loans are given out, the higher the risk of losing money. NBFCs are known to chase riskier clients for higher yields. Choose wisely.
3. Concentrated loan book
Lending to only companies in one sector can be disastrous. We all know how the housing sector is stressed. Recently, major housing finance firms defaulting back to back on bad loans in the realty sector. This started with DHFL (Read more on What happened with finance firm DHFL?)
4. Fast growing does not mean it is quality.
Be wary of banks that are growing very fast! A good example is YES Bank (Read What went wrong at YES bank?)
5. Retail loans vs Corporate loans
Retail loans are not automatically safe, whereas Corporate loans are not automatically NPAs. The general belief among investors is that retail loans are safer than corporate loans (Read more on this here). In this COVID pandemic, many retail loan consumers have opted moratorium, and therefore finance companies are at a higher risk of an increase in retail defaults.
6. Management commentary
Closely watch the management commentary. You can watch interviews of management on business news channels. Also, you can read con-call transcripts available on the firm’s website.
7. High Capital Adequacy Ratio (CAR)
Stick to the banks with a high capital adequacy ratio. High CAR again means the banks have enough cushion to absorb a reasonable amount of losses.
8. CET1 Ratio
CET1 ratio tells us how much instant money do banks and NBFCs have to conduct business or cope with loan stress.
9. Restructuring loans
Banks try to restructure loans when in trouble. Loan/debt restructuring in simple terms refers to changing existing loan contract terms for the borrower. Keep a track of how much of a loan is being restructured, if the restructured loans are a higher percentage of the total loan book then something is fishy! Stay on alert.
10. Promoters Control
Promoters are owners of a company. A common belief is promoters give their sweat and blood to take the company to greater heights. But recently there are instances which contradict this statement (Read more on how Rana Kapoor laundered money here). More than enough control can allow promoters to manipulate how the company functions leading to unethical business practices and governance. Be cautious!
How to judge and where to find most of above information?
- Read investor conference call transcripts.
- Read investor presentations.
- Read or watch management interviews on the business news channels.
- Understand more on NPAs and track NPAs.
Keep in mind, one has to be very careful while analyzing and picking a quality bank or NBFC to invest. Never rely on tips to invest your hard-earned money. Share your thoughts down below in the comments. Happy Investing! Peace!
Thank you Amit. Keep sharing! Keep reading more!
Well I have a perspective of having a regular check on the investments using different parameters as we had cases like IL&FS crisis Yes Bank Fraud.But the NBFC has an undoubted potential as a sector for short term as well as long term with growth trajectory about 10X.
Great thanks for your opinion Prashant. Please read more on RBI’s new guidelines to classify NPA. On the other hand NBFC raise money from banks, and banks are skeptical to provide funds to NBFC. If you are investing in NBFC then you should know cost of funds raised, how many borrowers have/will opt for moratorium, and more importantly how they plan to manage potential bad loans due to this Covid.
Leave a Reply Cancel reply
Meet the Author
A software engineer, trying to steer his way to financial freedom. In my journey, I come across many resources and experiences. I wish to journal every such experience here on my blog. I invest in stocks of NSE-BSE and also invest in mutual funds. All of the information I share here is strictly to educate my blog readers and help them start or manage their own journey towards financial freedom.Learn more
- Investing Guide (9)
- Longterm Investing (5)
- My Learnings (1)
- Other Income (1)
- Personal Finance (1)
- Short Learnings (3)
* You will receive the latest news and updates on your favorite celebrities!
Nicely explained. Happy investing !