Three Things Pramod Gubbi Says Investors Should Look At While Picking Financial Stocks

While financial sector companies, like all other sectors, will see its strong companies get stronger, the benefit of survival is far more disproportionate in this segment, the co-founder of one of India’s best portfolio management firms, which manages assets worth Rs 1,500 crore as of May, told BloombergQuint in an interview.

The coronavirus lockdown, which shuttered businesses and left millions jobless, is expected to push India’s economy toward a full-year contraction in more than four decades. To provide relief to borrowers, the Reserve Bank of India allowed lenders to offer a moratorium on loan repayments for six months. That may lead to a jump in the country’s bad loan ratio, already the world’s worst. India, according to Goldman Sachs, has the highest share of loans under moratorium across regions.

But prudence, according to Gubbi, can help make a good choice.

Non-performing assets will rise for each and every non-banking finance company and bank but the degree of rise will not be the same for all, he said. The companies that have been prudent, even during up-cycles, in terms of lending criteria, cost of capital and balance sheet will face fewer challenges during such a crisis and will be better positioned to gain, Gubbi said.

Here’s how Gubbi explains the three factors:

Lending Criteria: Better financial companies are the ones that are able to resist the temptation of greed, Gubbi said, because it’s easy to show growth in loan books when the economy is expanding. At that point if a lender keeps its underwriting strong, even if it comes at the cost if growth, the rewards are visible in a crisis like this, he said.

Low Cost Of Capital: Money is the raw material of a lender and low input cost translates to a lower yield curve, attracting more “sensible” borrowers, according to Gubbi. A higher yield curve is likely to attract borrowers that have been “shunned” by other banks or NBFCs, indicating a lower credit score.

Strong Balance Sheet: A strong balance sheet adds another layer of protection, Gubbi said. About the two NBFCs Marcellus is invested in, he said they have characteristics of banks — capital adequacy ratio northwards of 25% and a positive asset-liability portfolio.

“This is gold dust for NBFCs because most of them are the opposite where they borrow short and lend long and make spreads that way which is easy and don’t need competitive advantage. But when the cycle turns and yield curve flips, you’re stuck in asset-liability mismatch,” he said.

According to Gubbi, Marcellus’ investments do not focus on valuation multiples of financial companies. Instead, it chooses those that are trading lower than what it thinks is the most conservative intrinsic .

But “this crisis may justify a higher than historic valuation,” he said.

Watch the full conversation here...