A Compounding Miracle Hiding In Plain SightBloombergQuintOpinion
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. Over the past two decades, we find that:
1. The Bank Nifty has delivered far higher absolute returns than the Nifty (23% vs 14%);
2. 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;
3. High-quality financial services stocks have delivered better risk-adjusted returns than high-quality non-financial stocks across all time periods; and
4. High-quality financial services stocks have delivered positive returns in one out of every two market crashes even when the Bank Nifty has delivered negative returns.
Busting Some Myths Around India’s Financial Services Sector
The Bank Nifty has outperformed the Nifty by a massive 9% per annum over the past twenty years. As illustrated below, 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 one-year period basis so as to remove any bias due to the beginning and end 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 three-year or five-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 above, the Sharpe Ratio of the Bank Nifty over the period of March 2000 to September 2020 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 equal weight to the 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 the chart below, Stock A has a standard deviation almost twice that of stock B because the standard deviation penalises 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 the first chart, 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 Vs 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 services 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 greater than 10% revenue growth and greater than 15% ROCE in each of the preceding 10 years and compared it to lenders which generated greater than 15% loan book growth and greater than 15% RoE in each of the preceding 10 years. We created 11 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 greater than 15% loan book growth and greater than 15% RoE every year from FY91 to FY00 and non-financial companies that delivered greater than 10% revenue growth and greater than 15% ROCE every year from FY91 to FY00. The returns and standard deviations of these financial and non-financial companies were then compared over the next decade i.e. FY01 to FY10. 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 services companies delivered better Sharpe Ratios than the non-financial companies across all time periods.
As shown in the chart below, in each of the 11 portfolios the lenders delivered a higher Sharpe Ratio than the non-financial companies.
In seven of the 11 portfolios, the financial companies were less volatile—as measured by standard deviation—than the non-financial companies and in seven of the 11 portfolios, the financial companies delivered a higher return than the non-financial companies.
Bank Nifty as an index outperforms the Nifty by a wide margin when it comes to absolute returns as well as risk-adjusted returns. Even more specifically, a high-quality portfolio of Indian financial services stocks that consistently grow their earnings at 20-25% is 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 in 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.
Note: HDFC Bank and Kotak Bank are a part of most Marcellus’ portfolios.
Saurabh Mukherjea and Tej Shah are part of the investments team at Marcellus Investment Managers. Saurabh is the co-author of ‘The Victory Project: Six Steps to Peak Potential’ and ‘Coffee Can Investing: The Low Risk Route to Stupendous Wealth’.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.