Humanity’s fascination with gold is 4,500 years old. Current opinions &emotions about gold swing from it being an unproductive investment with no cashflows, to being a store of value, to being a
hedge against inflation & human madness, to being a measure of wealth, to being an investment
avenue, to being a bet against the declining dominance of USD and so on.

While all of the above arguments hold some water, it was the last opinion that caught our attention and called for more analysis. Before we get into more details, it is important to understand the three major sources of gold demand and their respective history:

• Ornaments: Indians & Chinese have historically been the largest consumers of gold ornaments and that demand has remained steady over the years. Annually, Indians & Chinese buy around 700 tons and 900 tons respectively. It is estimated that all Indians together own around 25,000 tons of gold, which is roughly 10% of world’s entire gold (and 3x the amount held by US Fed).
• Central Banks: Most central banks across the world hold a combination of gold, USD, and other foreign currencies in their reserves, since they are needed for exchange rate stability & trade settlement. Prior to 1974, gold used to constitute ~75% of global central banking reserves. Over the next 50 years, USD became more dominant and gold holdings as % of overall reserves touched an all-time low of 16% in 2016. This number has recently improved to ~20% due to actions of Chinese & Russian central banks (to reduce USD dependency).
• Investment demand: While this is the smallest sources of demand, it is important to note that over the last 50 years, gold has been completely dropped off from the portfolios of US & West Europeans. In a recent wealth survey, 71% of financial advisors in US said that their client’s allocation to gold is between 0% and 1%! This is not only the lowest in the history, but also very different from a typical Indian household which has up to 15% of its wealth in gold.

From the above factors, it is clear that two of the three sources of gold demand i.e. demand from Central Banks and demand for investment are close to their 50-year lows. Should one conclude from
this that the era of gold is over? Or is there anything to suggest that gold is set to reverse this 50-year trend of demand decline?

Can the central bank demand for gold rise?

Annual gold purchase by global central banks averaged around 400 tons during 2011-21, but surged to ~700 tons in 2022, buoyed by demand from China & Russia’s central banks. This period also
coincides with increasing geopolitical tensions – the global dominance of US is being increasingly challenged by countries like China & Russia. Smaller countries too are doing their bit by entering into
bilateral trade settlements (India-Iran), (Arab-China), etc.

In the past, US had successfully warded off the threats to its currency. But the recent situation seems a little different, because the world is increasingly getting exasperated with the America’s
gross misuse of USD’s reserve currency status (first in 2009 and then in 2020 by printing massive amounts of money). Thus, US will be busy fighting inflation, debt repayments, bond reissuances, and economic slowdown in the coming years and may not be able to effectively thwart the threat to USD.

In such a backdrop, non-US central banks may become keen to reduce their large stock of USD (China has already started) and diversify into other currencies or gold. Many macro commentators
opine that in periods of uncertainty, central banks a more likely to increase their gold holdings.

Can the investor demand for gold revive?

Since Indians and Chinese own gold in good quantities, the discussion here will pertain to investors in US, who over the years have almost shunned gold in favor of the typical 60:40 equity-debt
portfolio. The debt portfolios worked well for them (to reduce volatility) since interest rates in US have more-or-less declined in a straight line from 15% to 0% over the last 50 years.

However, that trend got broken in 2022 and interest rates rose from near zero levels to 5%. For the first time in 50 years, bond portfolios are seeing capital losses and witnessing volatility that is higher than gold. Right now, the hope is that interest rates will soon decline to 2-3% levels and the 60:40
portfolios will be repaired. If this does not materialize, investors will be forced to look at gold to
diversify their portfolios.

Is there enough gold to meet the above demand?

At an aggregate level, annual gold demand has remained static for many decades due to the above-mentioned reasons. In such a static demand environment, gold mining companies had no incentives
to look for new mines or improve their production efficiency. In case there is an additional demand for 300-tons on gold in 2024 due to the above-mentioned factors, there is no way that the mining companies can meet it. The new buyers will have no choice by to bid up gold prices.

What is the gold price telling us?

Gold price has made a lifetime high in many currencies including INR and is just 5% away from making new all-time highs even in USD. While this is a sign of strength, it assumes even more
significant because it has happened despite the sharp rise in interest rates in US (in the past, gold
prices would decline when bond yields increased).

US stock markets and gold has had an inverse correlation since 1950s. US markets did very well 1980-2000 and 2010-2021 while gold did very well in 1970-80 and 2000-2010. Based this, it seems
gold can do well between 2021-31. If one looks at the ratio of market value of Gold v/s S&P 500, it is
at depressed levels seen only twice in the history i.e. the inflationary era of 1970s and the tech bubble of 2000. We all know that gold prices rallied 2-3x in the years that followed.

What should investors do?

While no one can ever know with certainty if history will repeat, the current backdrop offers one of the most favorable environments for gold prices to rally. Ideally, we advocate investors to have 5-10% of their wealth in gold. But given the possibility of gold doing well in the next 2-4 years, one can
consider a slightly higher allocation as well.

Trivia – Update on Gold & Amul butter

India’s ancient economic & food sciences have assigned huge importance to Gold and Ghee, so much that Charaka Samhita, the Sanskrit text on Ayurveda, opines “sell your gold if you have to, but never stop eating ghee”. Thankfully, all of us are now in situation that we can own gold and eat butter as
well. Below is an illustration of how owning gold can ensure that you never have to worry about the
rising prices of ghee/butter!

Note: We do not understand or share the same optimism for Bitcoin and other crypto – currencies. Many of the data points mentioned in the above report have been obtained from blogs, articles and videos of investors whom we respect and follow. The above article should be treated as educational
and not be construed as an investment advice.

Analyzing the long-term case for investing in PSU Banks Let us analyze if the four key reasons that were responsible for the strong rally in PSU Banks are equally valid today or they have become stronger or weaker:

1. Reduced government interference: The bad lending practices that prevailed over 2009-14 were responsible for the NPA crisis of 2016-21. Reforms like PCA, IBC, merging weak Banks with strong ones, and inducting private sector talent were initiated. To us, the biggest reform seems to be the reduced government interference in lending and increased government oversight into systems, processes & people. That more or less continues till date.

2. Strong credit cycle: Indian Banking system has witnessed good credit growth and asset quality performance over FY22 & FY23. The good asset quality performance may extend well into FY24 & FY25 because indicators like corporate balance sheets, household savings, urban & rural
wages and real estate prices are strong. However, we may have already made a high base for growth and only those PSU Banks with capabilities in retail & SME may deliver double digit growth.

3. Building capabilities: Prior to 2018, most PSU Banks did not have capabilities to do retail lending or earn fee income that is not related to lending. Lately, we have seen that BoB, Indian Bank and Union Bank have taken initiatives to improve their retail capabilities. We have also seen that
tech solutions are increasingly being used to service the customers (Yono SBI). However, challenges around talent gap in the PSU banking sector remains high and success if any will be very slow.

4. Attractive valuations: In early 2021, we were at a juncture where most PSU Banks were trading at 0.4-0.8x book and growth & profitability (avg RoA = 0.4%) was about to improve. Two years later, growth and profitability both have improved (avg RoA = 0.8%), but so have the valuations
at 0.8x-3.0x book (table below). Thus, re-rating can no longer be a big lever and only those PSU Banks will re-rate who can demonstrate decent growth.



As we have seen from the above arguments, that the case for secular rally in all PSU Banks today is not as strong as it was in 2021. Hence, it’s time to adopt a stock specific approach. Based on the business strength, we classify the PSU Banks in to four categories:

Category 1 = SBI, BoB

• These are the most well-run PSU Banks and have some capabilities in retail & SME lending
• Credit costs are at their lows of 0.3-0.4% and RoAs are close to highs of 0.9-1.0%
• RoA improvement if any will be modest and may not sustain
• Valuations re-rating will be slow, that too if RoAs remain at these decent levels for FY24 & FY25
• Stock returns should be in-line book value growth or RoEs (Estimate for FY24 & FY25 = 15%)

Category 2 – Canara, Union

• They don’t have retail/SME capabilities of SBI or BoB, but they are better managed than others
• Credit costs for FY23 were around 0.8-1.2%, so there is scope for improvement in FY24 & FY25
• RoAs will touch 1%+ in FY24 & FY25, but eventually, it may revert to 0.8%
• Stock returns can be decent since there is re-rating potential in addition to book value
  compounding

Category 3 – PNB, BOI

• These are large PSU Banks, but rank one notch below Canara & Union in terms of capabilities.
• Credit costs for FY23 were around 1.2%, so big scope for improvement in FY24 & FY25
• RoAs will touch 0.6-0.9% in FY24/FY25, but eventually, it may revert to 0.7%
• Stocks have already run-up, re-rating potential is limited

Category 4 – Smaller PSU Banks

• They rank lowest in terms of business capabilities (CASA ratio, fee income profile, retail lending)
• Currently, they are reporting RoAs of 1%+, but once the NPA recoveries are over, RoAs will
  revert to lower levels of 0.6%
• Hence, they should not be trading above book value. But since the free float is very low (govt
  holds more than 90%) and there is buzz about privatization, there is irrational exuberance here.
• Valuations re-rating will be slow, that too if RoAs remain at these decent levels for FY24 & FY25
• Unless privatization plays out, investors in this category can see good amount of pull-back.

Currently, the issues that are worrying the investors in PSU Banks are the problem of peak NIM and the impact of IND-AS migration. We believe that NIMs will stabilize in the next two quarters and till then, the improvement in credit costs will help in sustaining the profits. The worry on IND-AS migration is a little too early in the day, since by FY26, the ECL model will have data related to 3 good years i.e. FY23, FY24, FY25 and this may result in a much lower provisioning number.

Many investors still believe that the entire PSU Banking pack can re-rate further by 10-20% (that fair valuation for SBI can expand from 1.3x to 1.5x; and that will commensurately push up valuations for all other PSU Banks). However, we don’t want to base our investment thesis on sector level macro
assumption, since our micro analysis suggests that the only a few PSU Banks have the room for growth & asset quality surprise.

Disclaimer: We are SEBI registered investment advisors and Research analysts and would have recommended some of the stocks or bonds to our clients. The above views reflect our independent judgement at current point in time and should not be construed as investment advice.

Microfinance (MFI) & 2W finance were the worst impacted amongst the various segments of BFSI sector. While 2W finance is still struggling to recover, the recovery in MFI sector started sometime in mid of 2022 and the Q3FY23 results & commentaries of various players suggest that the momentum is set to get stronger. The current macro & micro set-up for the MFI sector can be termed as the “goldilocks situation” due to the following reasons:

1. Lower loan losses: Pandemic pain for most players is about to get over. Since we are in the early stages of the cycle, most of the analyst estimates suggest losses of less than 2% for FY24 vs. 3-5% seen over the pandemic years.

2. Explosion in the “income” line item: Post the revised RBI guidelines, most MFIs have hiked theirlending rates by 200-350bps. Also, in absence of fresh NPAs, there will no interest income reversals. Thus, after a long time, MFIs will earn “full card rate” on the entire portfolio.

3. Strong loan book growth: After a long time, loan book is set to grow by 25-40% in FY24 for
various players. In the near term, growth creates its own virtuous cycle in terms of operating leverage and the repayment behavior of clients, both of which adds to the bottom-line.

How long can the upcycle last?
While most of the reasons stated above are well known & talked about, the biggest unknown is the length of the upcycle. If one looks at all the past cycles, it appears that the cycles are getting shorter. May be because the sector is far more penetrated & matured than a decade ago. Or may be the sector has grown faster than inherent capabilities of the underlying borrower.

*Source: MFIN Micrometer, company drhp, Greenedge Research

Are there any major unseen risks?
Another aspect which makes us circumspect about the length of the cycle beyond FY24 is the 200-350bps lending rate hike taken by various players. These hikes are larger than warranted by rise in borrowing costs. Post the AP crisis, the large MFIs developed a view that lending rates below 20% significantly reduces the risk of political interference. To that regard, lending rates of large MFIs like SKS, Bandhan, Ujjivan, Credit access remained in the 18-20% band over 2016-20.

But so deep were the covid losses, that MFIs have raised lending rates by 200-350bps to repair their balance sheets and we are once again in the 22% range. This despite the 10x increase in size and manifold increase in technology usage over the last 8 years. It tells us about how difficult the segment is and that one cannot write-off the soft political risks. As equity investors, the best we can do is not to assign peak valuations to peak earnings of FY24.

Company section
Despite the different regulatory structures i.e. NBFC-MFI, SFBs or NBFCs, microfinance sector has generally been homogeneous – most players follow some form of JLG model, they grow fast in an upcycle and they lose a good amount in downcycle. But beyond this, there are subtle differences like geographic diversification, process diligence, ability to manage large number of employees, and leverage. For a good player, all of the above factors culminate into relatively lower credit losses in bad cycles. Below is list of losses suffered by major listed players.

Credit losses of MFI players

*Source: Company presentations; (assumes that all provisions relate to MFI loan book that was existing just when covid hit)

Bandhan Bank (CMP = 230; Mcap = 36,500cr)

Long term assessment: It is India’s largest MFI and stands out for being the worst impacted as well.Apart from the pandemic generated pain, company specific factors include lack of geographic diversification (>50% of MFI book in West Bengal & Assam), overleveraging its customers under the garb of warding-off competition (average ticket size was 2-3x of industry) and extreme under-investments in non-MFI businesses (branches, sales, technology, brand).

Until as late as Sep’21, management attributed most of the problems to the pandemic. The deep losses even after the huge write-offs in FY22 has probably forced to change track and talk about asset & geographic diversification. Even if the intent is whole hearted, it will take years of investments in tech, people and processes to build a good bank (which means much higher opex). Till then, earnings will continue to be extremely cyclical with huge dominance of microfinance on the asset side and highly interest rate sensitive customers on the liability side.

Short term assessment:The benign macro cycle offers some hope in the interim. If most of write-offs are genuinely over in FY23, Bandhan can report a big jump in profits in FY24 courtesy the 200-250bps lending rate hike, improvement in % of assets that will earn interest (reduction in stressed portfolio) and sharp reduction in loan losses.

Source: Company presentations; (projections are just for illustrative purpose)

Valuation: Despite trading 50% below the pre-pandemic levels, current valuations at 1.9x on Mar’23
aren’t exactly cheap, given the deeply cyclical nature of its business. If FY24 is indeed a good year for earnings, the stock can give 20-30% returns, in-line with the increase in its networth. Anything beyond this should be contingent on the management’s ability to reduce the cyclicality of its business model.

Ujjivan SFB (CMP = 27; Mcap = 5,200cr)

Long term assessment: Apart from being one of the well-run MFIs, Ujjivan had the distinction of
being the most geographically diversified MFI as well. However, things changed post conversion to small bank. Their initial strategy around branches & liabilities misfired. They then tried to rope in a banker CEO, but that strategy too failed. The old founder re-took control of the management in late 2021.

Amidst all this, Ujjivan still remains a well-run MFI. But its banking piece continues to struggle. Despite spending 1,000s of crores in opex, its liability franchise as well as fee income (non-lending related) franchise remains weak. It is indicative of two things – that banking franchise is extremely tough to build despite throwing lot of money on it and that the MFI mindset still reigns supreme within the company. 70% loan book and 90%+ of profits still come from the MFI business which is deeply cyclical. Any change in this will be very gradual.

Short term assessment: Ujjivan is already reporting an upswing in FY23 earnings due to early
recognition of losses (9MFY23 losses are close to zero) and having raised lending rates from 19% to 21% in May’22. It may not be easy to grow earnings at double digit rate over the base of FY23 since Ujjivan will have to contend with rising deposit costs & normalization of credit losses in FY24.

Source: Company presentations; (projections are just for illustrative purpose)

Valuation: Stock trades at 1.25x on FY23 book value, which isn’t expensive. But given that cross-cycle RoEs are around 10% or close to cost-of-capital, it’s not easy to build a case for permanent improvement in valuations. Stock can give 20-30% upside in next 12 months purely based on book value compounding. Returns beyond that depends on the length of MFI cycle and ability to reduce
cyclicality of earnings.

Despite much higher MFI losses, Bandhan has higher RoAs & RoEs compared to Ujjivan. This is because Ujjivan has spent much more than Bandhan in trying to build a banking franchise. It’s a different matter that both remain heavily dependent on MFI sector and have to offer high rates to attract depositors.

Suryoday SFB (CMP = 99; Mcap = 1,050cr)It is the smallest among listed SFBs. In many areas of life, small can be beautiful. But this is surely not true in the banking domain, where scale becomes very important to success. The small scale of operations doesn’t allow Suryoday to spend much on banking franchise (CASA = 9% of borrowings) and its not possible to scale profitably without spending. It’s more like a chicken and egg problem.The pandemic performance of its MFI book (~65% of total loans) puts it in mid-tier amongst the MFIs. While the cyclical upturn will lift all boats including Suryoday, small size is going to remain an
impediment for times to come. Valuations at 0.7x current book is the only comforting factor.

Credit Access Grameen (CMP = 990; Mcap = 15,500cr)

Long term assessment: CAG is India’s largest NBFC-MFI and also one of the best run MFIs, visible in the lowest credit losses during the pandemic and the fastest return to profitability. This despite having acquired a mid-sized MFI just before the start of pandemic speaks volumes about the management ability. Operating in rural areas and following the best practices in terms of collections & customer leveraging, Credit Access is the cleanest play in the NBFC-MFI space.

Short term assessment: Upswing in earnings has already started in Q3FY23. With good growth,higher lending rates and cyclically low credit costs, FY24 will witness 5%+ RoAs.

Source: Company presentations; (projections are just for illustrative purpose)

Valuations: Current valuations at 3.3x on FY23 book adequately reflect the relatively lower cyclicality in earnings and management pedigree. Expecting valuation expansion from here isn’t a good idea since we have seen in the past two down cycles (demon & covid) that even the best players suffercyclicality in this sector. Thus, the best case here should be book value compounding or 15-25% returns in FY24.

One point to note here is that well run NBFC-MFIs trade at higher valuations v/s Bank-MFIs. Part of the reason is NBFCs don’t have to spend huge money on building a banking franchise (and we have seen poor outcomes from most SFBs except Equitas & AU) and there is always an option value interms of a large bank acquiring the NBFC-MFI.

Fusion MFI (CMP = 400; Mcap = 4,000cr)

Long term assessment: Fusion MFI has been one of the fastest growing MFIs in the past 7 years and also among the better geographically diversified. Ability to continuously raise equity capital at the right time has enabled it to grow through demonetization as well as pandemic. The credit losses look optically low due to the high growth, but when one looks at static pool analysis, Fusion’s asset quality performance is mid-tier (23% losses on Mar’20 portfolio).

Fusion’s loan book has grown by 12x in past 7 years or 45% CAGR, which is almost 2x of the sector growth. Generally speaking, MFI business is very operations intensive in terms of getting the right staff & establishing right processes. Pulling off such high growth without any lose ends will be a sort of miracle (but miracles do happen). Not to mention that over the past few years, there were
disputes between the original founders, private equity investors & SIBDI (details available in drhp) and the founder promoter has less than 5% equity left in the company.

Short term assessment: We have already seen two good quarters post the IPO. The fund raise andthe benign macro will ensure this continues for FY24 as well.

Source: Company presentations; (projections are just for illustrative purpose)

Valuations: Current valuations at 1.8x on FY23 book look reasonable when compared to well-run MFIs like CreditAccess and Arman. May be the market is adequately building in for risks-factors like large un-seasoned book, low promoter stake and average RoEs across cycle of ~11%.

Spandan Sphoorty (CMP = 600; Mcap = 4,260cr)

Long term assessment: Spandana has crossed many critical milestones – survived AP crisis, emerged out of CDR, withered the pandemic storm and stabilized after the bitter fight between ex-founder and current promoter. After all this, the balance sheet still remains well capitalized and the new management is in place and working towards re-establishing the building blocks i.e. people,
processes & raw material. If the execution is good, FY24 can be the first significant year of profits.

Short term assessment: Borrowing costs are slated to go up, since Spandana is re-starting its relationship with lenders. But that will more than adequately be off-set by increase in lending rates (200bps higher than competitors). FY24 can be the first year of mid-teen RoEs. However, Spandana will have to moderate its strategy of higher borrowing & lending rates, once things stabilize.

Source: Company presentations; (projections are just for illustrative purpose)

Valuations: Current valuations at 1.3x on FY23 reflect the chequered past and a modest future. If the management is able to demonstrate good growth and profitability, there is some scope for improvement in valuations.

Arman (CMP = 1405; Mcap = 1,193cr)

Long term assessment: Arman is small but well-run MFI. It ticks many boxes including good geographic diversification, highly profitable operations, lowest credit losses during demonetization & pandemic, and highest shareholding by founder-promoter. High involvement of the founders and adequate risk management should ensure that Arman will continue to be better than the sector in years to come.

Valuations: Current valuations at 3.4x on FY23 book adequately reflect the “better than sector” long term performance. Investors can continue to expect book value compounding for the years to come.

Investor strategy – Create a barbel!

Given the high certainty in the near term and the usual uncertainty in the long term, investors are better off playing the barbel strategy i.e. to own a combination of well-run MFI (which will at least ensure book value compounding) and a turning around MFI (which can give higher returns IF the turnaround happens)!

• Barbel 1:CreditAccess, Arman
• Barbel 2:Bandhan, Ujjivan, Spandana

For those who do not like investing in deeply cyclical sectors, they can invest in short duration bonds of some of the MFIs. Balance sheets are well capitalized, macro cycle is benign and micro looks strong for FY24. Many of these bonds offer yields in the range of 11-12% and are a part of GreenEdge Wealth’s high yield bond baskets.

Disclaimer: We are SEBI registered investment advisors and Research analysts and would have recommended some of the stocks or bonds to our clients. The above views reflect our independent judgement at current point in time and should not be construed as investment advice.

Cyclicality in microfinance sector is as old as the sector itself. A good cycle usually lasts for few years and is inevitably followed by bad cycle. The sector witnessed its worst cycle over 2019-21 courtesy the build-up that happened over 2017-19 and the disruptions caused by the pandemic. Over the past two years, most MFI players have provided for or written-off around 10-20% of their portfolios.

Credit losses of MFI players

*Annualized as on Dec21 or Mar22, whichever is available

Amidst all this, the good news is that we are nearing the end of the bad cycle; many MFIs are solvent even after absorbing such high losses; and the macros are turning favorable (since India’s informal & rural economy is finally recovering from the pandemic shock). For NBFC-MFIs, this is an additional positive due to the recently announced RBI guidelines. We can expect 18-24 months of strong growth and profitability for the sector in general and NBFC-MFIs in specific.

Profits for most of NBFC-MFI can double from the low base of FY22 just out of credit losses reverting to pre-pandemic levels (good cycle). In our assessment, most of the players will be able to grow between 15-30% CAGR over next two years and that can provide an even bigger boost to profits. The future assumptions in the above & below table are purely for illustrative purposes and should not be construed as an accurate projection.

Profit potential of MFI players

*Annualized as on Dec21 or Mar22, whichever is available

Let’s turn our attention to individual players. MFI is cyclical business and being adequately capitalized helps during downturns. Also, MFI is a very operations intensive business i.e. it involves heavy reliance on employees, frequently meeting the customers, and maintaining the sanctity of everyday processes. The MFIs with robust operations usually enjoy higher profits in good times and suffer lesser losses in bad times. This is precisely the kind of player you may want to invest in.

How the valuations stack up

Bandhan Bank is India’s largest MFI and was also the worst impacted. Some of the reasons for this were its high concentration in West Bengal (46%) and Assam (14%), high ticket size of loans and underinvestment in non-MFI businesses. While there is no denying that there will be a cyclical recovery in profits, long term investors in the stock have to grapple with the above-mentioned structural issues. Another point working against Bandhan Bank is its bloated equity base, courtesy the super expensive acquisition of GRUH Finance. This will further increase in FY23 as it will need to raise capital for growth.

Credit Access Grameen is India’s largest NBFC-MFI and also one of the best run MFIs. It boasts of the lowest credit losses in the pandemic period (10% of loan book) despite having acquired a mid-sized MFI just before the start of pandemic. Operating in rural areas and following the best practices in terms of collections & customer leveraging, Credit Access is the cleanest play in the NBFC-MFI space. Current valuations partially reflect rosy future, but compounding returns are still possible.

Spandana is bitter sweet story – it was the only MFI that survived AP crisis & emerged from CDR, thanks to the efforts of its founder-promoter and the capital support given by Kedaraa Private Equity. However, an ugly corporate battle broke between the founder promoter and the private equity in late 2021. Although Spandana is well capitalized and well provided, such altercations can impact ground operations. The MFI upcycle has started; stock is trading at throwaway valuation; only if the quarreling promoters can resolve the differences, Spandana has many low hanging fruits that it can pluck.

Arman is very small but well-run MFI. It ticks many boxes including good geographic diversification and highly profitable operations. The only problem here is the low float and rich valuations. The company has to grow at 50% CAGR for investors to make meaningful money from current prices.

MAS Financial is engaged in the business of wholesale lending to hundreds of MFIs and small NBFCs. However, MAS couldn’t reduce its own borrowing costs meaningfully over the years and is facing competition from many large NBFCs in this segment. It is substantially under-invested in direct lending and valuations are not cheap either.

Things to ponder for the long term!
The upcycle has started for sure, but the extent and duration will depend on several factors like growth in household incomes, competitive intensity, liquidity, etc. In the past, we have seen that the urge to grow fast has led to indiscriminate lending by banks as well as NBFC MFI players, in turn resulting in customer over-leverage. A look at the below table can summarizes the customer overleverage that transpired in the microfinance sector in the five years preceding the pandemic.

Source: Economic Times, MFIN, SADHAN

In the past, RBI’s efforts to contain this have been cleverly circumvented. Let’s hope that the new guidelines are followed in spirit as well and the sector can witness a longer upcycle. Otherwise, it will be difficult to have a long-term view on the sector as well as the stocks. Investors can also consider investing in short term bonds of lenders like Credit Access, Spandana, Asirvad, etc since they offer immense safety and good yields.

All through the last 10 years, there has been a simple linkage between gold price and the perception of performance of gold loan NBFCs. If gold prices went up, stocks of gold loan NBFCs like Muthoot & Manappuram would do well and vice-versa if the prices went down. This simple correlation was based on the understanding that if gold prices go up, loan growth improves, operating leverage kicks-in, auctions reduce and profitability improves.

Thumb rules work, till they stop working: The above-mentioned correlation seems to have broken down in last twelve months. The stock prices of Muthoot and Manappuram have been weak despite the 10% improvement in gold prices and the improved outlook for gold (due to inflation and the war related uncertainties). One can argue that the weak performance of these stocks could be due to the muted growth & high auctions in the past 2-3 quarters. But one can immediately counter argue that stock prices are more reflective of what can happen in the future and that future growth prospects for gold loan sector looks bright given the firmness in gold prices and opening up of Indian economy. What then explains the underperformance?

Competitive intensity is the joker in the pack: Over FY15-20, retail gold loan sector was growing at mere 8-10% CAGR and accounted for less than 1% of India’s total outstanding loans. This coupled with operationally intensive nature of gold loan business ensured that most banks stayed away from this segment and specialized NBFCs were able to not only grow well but also improve their profitability to remarkable levels.

This goldilocks scenario seems to have been disturbed with many new players entering the gold loan arena. As we can see from the table below, relatively new entrants like SBI, CSB, Federal Bank, Fed Fina, etc have created decent sized gold loan portfolios. To add to this, there are players like ICICI Bank & Bajaj Finance who have also joined the bandwagon but do not report the gold loan AUMs separately.

Lending yields are currently under pressure: Until 2020, it was believed that banks will not venture into gold loan business meaningfully due to operationally intensive nature of the business. But given that most lending avenues were running dry post IL&FS crisis in Sep18, many banks have started to look at this niche and highly profitable lending segment. While SBI & CSB rely on internal resources to run the gold loan business, Federal Bank, Karur Vysya and ICICI Bank have entered into symbiotic relationship with start-ups like Rupeek & Indiagold to do the front-end for them.

All this has resulted in price war between banks & NBFCs and within NBFCs too and yields for NBFCs have been under pressure. At the peak of the price war in Sep’21, many banks and NBFCs were offering large ticket gold loans at 6-8%!

Is the damage temporary or permanent: Stock prices of Gold loan NBFCs look cheap even if one looks at them on TTM P/E ratio. The subdued stock prices for Muthoot and Manappuram despite attractive valuations seems to be Mr. Market’s message to investors – “competition is here to stay, the best of lending yields & profitability are behind us, let us wait and watch as to how much lower do the settle”

1. Muthoot Finance is the gold standard in gold loan segment with best-in-class brand, liability profile and operating cost structure. While there is little doubt that it will remain the leader in the coming decade as well, but profitability (RoAs) over the coming years will probably settle at 100-150bps lower vs FY21 levels. Competition in 2lac+ ticket size is here to stay as a leader, Muthoot will have no option but to keep fighting in this segment. The less than 1lac ticket size represents a large & profitable opportunity, but the branches have to keep running to maintain & grow this part of the loan book.

2. Manappuram Finance has a much tougher job at hand. Its higher operating costs (2x v/s Muthoot) will not allow it to compete in the 2lac+ ticket size and it will have to do the hard work of originating smaller ticket sized loans, where yields are still upwards of 18%.

3. IIFL Finance is somewhat in a sweeter spot because it never had sky high RoAs in the first place. And the old branches have reached critical mass needed to keep operating costs low.

Make no mistakes that this is not a start-up driven disruption. The gold loan start-ups continue to burn money and are yet to come up with any path-breaking innovation on any aspect of gold loan business. The competition seems to be from banks in general and in some cases, the symbiotic partnership between start-ups and banks.

The bull, bear & base cases: The bull case for gold loan NBFCs seem to be that the competition is temporary and we will see a sharp bounce back in growth & profitability. The bear case represents sustained increase in competition and 2-to-3-year period of yield compression. In that case, multiples will de-rate further unless they are able to diversify into new areas of lending. The base case is that the profitability adjustment phase ends in a few quarters, RoAs will settle around 5-6% range, and there is enough room for everyone to grow at 10-15% CAGR. In this case, the stocks will continue to underperform / consolidate. Currently, we are neither in the bull or the bear camp and will stick to the base case.

Note: The data used above has been taken from company presentations or annual reports. We would like to thank our friends working in gold loan industry for helping us decipher the trends and plugging the gaps in our understand. If you have any observations on the above article you write to us on [email protected]

Q1FY22 represented a perfect storm for the gold loan sector. Gold prices had crashed 15% towards the end of Q4FY21, lock-downs had impacted demand as well as ability of customers of earn & repay, and banks had to deal with additional problem of lowering LTVs from 83% to 68%. It was no surprise that most players witnessed de-growth in loan book, rise in NPAs and subdued profitability for the quarter. Tough times generally separate the men from boys. Muthoot Finance & Manappuram had emerged as “men” in the last downcycle (FY13-16). Let us observe what the current cycle is trying to tell us.

Banks: Gold loan has never been a high priority product for banks due to the operational challenges surrounding this business. But the rally in gold prices since 2019, lack of avenues to grow elsewhere in the post IL&FS economy and RBI relaxation on LTVs during the Covid year nudged a few banks to go aggressive on gold loans. SBI and CSB were at the forefront, lending at 83% LTVs and grew 460% and 61% respectively in FY21.

Then came the perfect storm of Q1FY22. While AUM growth was flat to negative, NPAs spiked sharply. CSB clearly articulated that they will be focusing on collections and auctions in the coming quarters rather than growth. While SBI didn’t talk much on gold loans, they may also have to spend some time in learning “how to manage the down cycle”

*Investor presentations & concalls

NBFCs: NBFCs didn’t have to deal with LTV changes as they were not granted any special
dispensation either. Yet, the other two storms i.e. gold price fall and lockdowns had to be grappled
with. Except for Manappuram, the large gold loan NBFCs fared much better than their banking
counter parts, thanks to their learnings from the previous cycles.

*Investor presentations & concalls

Why is Muthoot Finance’s performance exceptional?

Unscathed by the storm: Despite the strong loan book growth over past two years, muthoot could manage this storm with flat loan book, negligible rise in NPAs, negligible auctions at INR1.3bn and a double-digit growth guidance for the whole of FY22! Management is clearly indicating hat they are not damaged in the storm but are ready for future growth. While there are many reasons like their past experience, well-oiled collection machinery, conservative lending standards, etc, the most important reason seems to their cost leadership. Let’s delve a little deeper.

The virtuous cycle of cost leadership: Like most corporates, Muthoot Finance too likes to maintain its margins & profitability. In the early years (2010-13), competition was low, operating costs were very high and charging higher interest rates (16-24%) were vital for NBFCs to maintain profitability.But as years passed, the branches become more productive, operating costs started reducing. The management was quick to pass the benefits to customers in form of lower interest rates. This in turn helped the company to get access to better quality customers and higher loan growth. This further increased their branch productivity and reduced operating costs again. The virtuous cycle continues till day.

Competing with banks, yet profitable like an NBFC: Thanks to its cost leadership, Muthoot has products that allow it to lend across the spectrum of banks as well as NBFCs (10-21%). As such, it is able to access prime customers compared to its NBFC counter parts and that has been one of
reasons why the customer stress was so low during the current storm. Another thing to note is that the reduction in lending rates hasn’t resulted in reduction of profitability. In-fact profitability is at its best ever. Profitability built on basis of cost leadership is the most sustainable kind of profitability.

One explanation for it’s ability to generate 21% yield at the portfolio level despite lending at lower
rates is the high levels of activity at its branches (lot of loans are originated & settled within the quarter, which improves the yield on quarter ending loan book).

Is this the Titan moment for Muthoot Finance?

Somewhere in 2015-17, it became clear that Titan’s jewellery business was “breaking out” of the pack i.e. it had become significantly stronger than its closest competitors. The stock got re-rated significantly because market participants realized that over next 10 years, Tanishq will capture very
large part of the profit pool of the jewelry industry in India. We have seen similar trends happen with Hatsun in Dairy space in 2016-19, Cholamandalam in CV space in 2016-18, AU Bank in the small finance bank space in 2017-19.

Is this a similar moment in gold loan space? Time will be the best judge but the stars are aligned.
Manappuram has a long road ahead, as it has to change its strategy of high yield lending. IIFL Finance has got its strategy around gold loans absolutely right (selecting operating leverage over higher ending rates), but is has to deal with high borrowing costs, other problematic areas like MFI, developer, LAP, and has a much smaller branch network. And valuations of Muthoot Finance are amongst the lowest for leaders.

Trivia – How tech savvy is the gold loan business?

India’s most valued Fintech company i.e. Bajaj Finance too has joined the gold loan bandwagon. Even more enlightening is the fact that it is taking the old brick & mortar route i.e. opening 25 new physical branches (12 in Jaipur & 13 in Vaizag) exclusively for gold loans! May be that’s as much tech as gold loan business needs! Should investors not be bullish on the best player in this space, where everyone else is seeing so much merit in this business?

As investors, we may be tempted to think that last few quarters should be treated as “exceptional” due to cyclones, special situation in Assam & West Bengal, and finally the Covid pandemic. It’s surely a good thing to be hopeful and try and see light at the end of the tunnel. But it may not be a bad idea to try and understand if COVID was the only reason for the current state of the industry!

Let’s rewind a little to 2018 The NBFC sector was the epicenter of the IL&FS storm, when credit markets froze in Sep, 2018. Even the well-run NBFCs were lying low and waiting for the tide to subside. But one sub-sector seemed to be quite unaffected and never faced funding crunch, thanks to the priority sector status. The MFIs became the darlings of investors – unfazed, unaffected, and delivering on the promise of 30% CAGR and sub 2% credit losses for the entire FY19 and FY20!

Source: Company presentations

Did the average rural customer need so much money?

The MFI sector was flush with funds, both debt and equity. And they were in a hurry to grow and deliver on the 30% CAGR promise. The MFIs wasted no time and took the path to easy growth i.e.lend more to the same set of existing clients. Bandhan Bank increased its ticket size by 2-3x under the narrative of “completely dominating” the ustomer; Credit Access designed innovative products to lend more to the same customer.

Ultimately, there was low consideration for the basic question i.e. did the rural borrower need so much money? And will she be able to repay? A look at the below table can summarize what transpired in the microfinance sector in the five years preceding the pandemic. Given the slowness in Indian economy, an average rural household could only grow its income by 23%. However, his outstanding debt increased by 106% over that period, thanks to the zealous growth targets of MFIs.

Source: Economic Times, MFIN, SADHAN

Overleveraged customer could be the bigger cause; Covid was just the trigger!

As we saw in the table above, we might be in a situation where millions of rural folks have more loans on their heads than they could afford to repay. And then Covid struck. While Covid is no small event, we do know that even a medium sized pot-hole is enough to topple an overloaded vehicle. The signs of stress among the borrowers are clearly visible from the decline in repayment rates over the years. Most of the MFIs explained that they are giving longer duration loans but that doesn’t explain the extent of drop in collections.

Source: Company data, GreenEdge

Is there light at the end of the tunnel?

The current outcome is a far cry from original promise of the microfinance model i.e. there is tremendous growth opportunity in rural India; and that lending exclusively to groups of women is an extremely low risk model. Four large MFIs have reported combined provisions / losses of ~Rs6,000crs or 7% of their pre-Covid portfolio and the damage caused by the 2 nd wave is yet to unfold.

Source: Company data, GreenEdge

We need to understand that an average rural Indian family cannot remain unscathed when faced with two bad events in a single year. Hence, microfinance companies may experience similar levels of pain in FY22 as well. But the good part about all the external problems is that they come to an end.

The 2 nd wave will end in a few months and most of these large companies either have a strong capital base or will raise capital to absorb the losses. The regulator on its part is doing all it can to ensure that MFIs have access to liquidity till the pandemic ends. Hence, the worst will be over in FY22. The stock prices & valuations of these MFIs somewhat reflect this optimism.

Source: Based of Mar’21 financials

The bigger question for the long-term investors should be “is it sustainable to grow at 30-40% when your under-lying customer is growing only at 6-8%”. In the past, investors have expected nothing less than 30% growth from MFIs and managements have promised only more! Microfinance sector will continue to see boom & burst cycles unless growth ambitions & aspirations are re-calibrated.

It was refreshing to meet some old friends outside a popular sandwich joint; especially after being home confined for almost 7 months. An unsaid ritual of sorts, I was asked for a “stock tip”. This time, I shared that ‘Gold’ seems attractive for the next few years.

On expected lines, one of them quickly retorted “Markets are on steroids, so many stocks are flying up 5% & 10% daily. Of all the stocks in the world, you want us to buy gold, which is already at Rs. 50,000!”. Surely, a lot of people would have resonated with my friend’s impatience – that there is an eleven course buffet meal going on and we are suggesting to eat some mundane “dal-chawal”.

Well, the boring advice comes from our assessment that the stock market party is surely not in its early stages. A large part of economic recovery which may happen in 2021 has already been celebrated by the stock markets. Hence, at this stage the risk-reward for a new investor may not be extremely rosy. Read below on why we think that gold offers good risk reward:

Possibilities that can reward gold

1) Inflation can raise its head soon: Prices of oil, gas, metals and other materials have been extremely subdued since out-break of Covid. Prices may start going up as economies across the globe start opening up. Many ‘suppliers’ of these commodities have gone bust in the difficult post-Covid world. As such, there could be a situation that supplies don’t keep up pace with the demand. Gold typically does well when inflation in high.

2) Central Banks can slowly start withdrawing the stimulus: In order to save the global economy, trillions of dollars of monetary & fiscal stimulus have been given by central banks across the world. That has resulted in near zero interest rates across developed economies and low interest rates in India as well. While, this easy monetary policy can continue for next 12-24 months, some day the central banks will have to start reversing it.

3) Indian currency may depreciate to 80+ levels vs USD: India is a big importer of oil, gas and few more commodities. As demand goes up within India too, we will have import more and that too at higher prices. This coupled with central banks starting to withdraw the COVID stimulus could become the perfect backdrop for currency to weaken. We have seen what happened in 2013, when the US FED started to taper the stimulus given during Lehman crisis. (Rupee depreciated from 63 to 70 in a few months). All this bodes well for gold.

4) De-globalization & reducing dependency on China: Over last 20 years, China’s ever expanding low cost manufacturing kept global inflation under control. In the post Covid world, a lot of countries have expressed desire to reduce the dependence on China. This can add to long term global inflation.

Long term observations on gold

Preserves purchasing power: Relative to all other forms of currency, Gold has preserved purchasing power over long periods of time. Below is a simple example of AMUL butter that will help you understand the concept of purchasing power:

• Rupee lost 98% of its relative value in 50 years: One rupee could buy 100 gms AMUL butter in 1970s. Today, you can hardly buy 2 gms of butter for that amount.
• US$ lost 75% of its relative value in 50 years: Contrast this to the mighty US$, one dollar could buy 600 gms AMUL butter in 1970s. Today, it can fetch you only 150 gms.
• Gold has gained in relative value in 50 years: Contrast this with gold, 1 gm could buy 1.5 kg of AMUL butter in 1970s. Today, you can buy 11 kgs of AMUL butter with just 1 gm gold.

Hedge against madness: Over your lifespan, you would witness madness of various kinds. Those who had kept money in US bank deposits in 1930s, lot of that money could have evaporated as more than 300 banks collapsed in the Great Depression. More recently, those who were living in Zimbabwe and had savings in local currency, their entire worth would have reduced to a “loaf of bread” due to hyperinflation. Gold has preserved value through all kinds of human inflicted madness like wars, government failures, economic mismanagement, pandemic, etc.

Survivor for more than 2000 years: Gold has been in use as currency & store of value for more than 2000 years. Over time, many “alternatives” have tried to compete with gold. Each time there has been a beautiful narrative around the alternatives too. Some examples below:
• Silver & platinum were once touted as alternatives
• Oil was once called black gold
• US$ is a sort of reserve currency since last 100 years,
• Data is often touted as the new gold
• Crypto currencies are recently being compared to gold

However, let us not forget that time erodes the importance of most of these alternatives. Even the mighty US$ has been the reserve currency since the last 60 years only. Gold has a recorded history of more than 2000 years!

The advent of digital gold
The last few years have witnessed emergence of some credible digital options. Government gold bonds, gold MFs and gold ETFs are some of those instruments. Govt gold bonds offer 3-5% discount to open market buyers and also the prospect of 2.5% annual interest. It’s probably the best mode of owning gold – you get discount, annual interest and the capital gains! More sophisticated investors can invest in gold mining funds or companies that benefit from rising gold prices. You can write back to [email protected] to explore more.

Disclaimer: The above article is for educational & informational purpose only and should not be construed as an investment advice. We may have totally different time horizon and perception of risk & reward compared to you. Hence, it’s best for you to consult an investment advisor.

Exasperated of being confined to home since Covid-19 outbreak, Mr. Kapoor & family finally decided to take a break and drive down from Mumbai to Khandala, a popular weekend getaway. While driving through Mumbai, his eyes fell on the glittering office buildings, first at the Bandra Kurla Complex (BKC) and later at Airoli/Ghansoli. A simple thought crossed his mind:

“This work from home (WFH) trend would have reduced the property prices here too. Once Covid is over, these offices will once again beam with employees and property owners will enjoy regular rental incomes & some price appreciation too. And surely, investing in these best-in-class office properties is safer than investing in plots in some unheard location. How I wish that a middle class person like me, with only Rs. 10-20 lacs to invest, could have bought a small office in one of these swanky buildings!”

Soon, Mr. Kapoor’s car entered the express way and his mind returned to his current reality that “I don’t have crores to invest, hence its best to forget those glass palaces”

Introducing REITs!

Mr. Kapoor has made peace with his thoughts, but what if someone told you that for as little as Rs. 100,000, you could own a small chunk of the swanky Express Towers (Nariman Point) or FIFC (BKC) or Gigaplex (Airoli) or Golf Links (Bangalore) or Raheja Tech Park (Hyderabad)? And that this investment of yours will sit in your demat account and you can earn 4-7% rental income annually and some property appreciation over the long term! Welcome to the world of Real Estate Investment Trust (REITs)!

How do REITs work?

REIT is a legal structure (regulated by SEBI) that allows you to own demat units of a large property or a group of properties. As a minority owner, you are entitled to a share of the rental income and the capital appreciation. However, you do not have any say in deciding “whom to lease the property” or “what rentals to charge” and that is typically managed by a professional management company. The builders of such large commercial properties (Rajeha, Embassy, Blackstone, Brookfield, etc) usually finance such projects through a combination of debt and equity. By allowing thousands of investors like you & me to purchase a stake, they can release a part of their money from the project and use it to fund other such projects.

• Benefits for you:

o You can have a stake in best of the properties for as little as Rs. 100,000;
o You can easily enter or exit your investment through your trading account;
o You do not carry any onus of the legalities, upkeep & leasing of the property;
o You earn 4-7% rental every year and also benefit as the property prices go up;
o Tax on rentals is ~15-20% depending on the REIT structure)

Risks in REIT investing

Although REITs have existed in US and other developed markets since early 2000s, it is a relatively new concept for the Indian markets. The key risks that one should be aware about are:

• Rental risk: Rental yields of 4-7% should not be treated as fixed as they can be impacted by certain forces. If the work from home concept continues for a long time, it is likely that some tenants may vacate a part of their occupied offices. For example, if a company like Accenture decides to vacate its Hyderabad Tech Park office, it will take a long time to find such a large tenant to fill the same occupancy.

• Property price risk: Prices of offices in India have corrected by 10-20% since the outbreak of Covid. As such, the existing investors of REITs have lost 10-20% on their investments. It will recoup only if the property prices rebound.

• Sponsor risk: The sponsors (Rahejas, Embassy, Blackstone, etc) of the REITs have the power to buy new properties & sell existing properties of the REIT. From the history of REITs in the US, we know that sometimes, the sponsors do not act in the best interest of their minority holders.

Overall View – Balanced benefits for the risks

Overall, REITs offer a range of conveniences to small investors like us – flexible tickets size, easy buy & sell, no legalities & up-keep hassle, stable income and long term appreciation. There are only two REITs listed in India and both of them boast of high quality sponsors, high grade properties and high grade tenants.

Like many Indians, Sonali prefers to park most of her savings in bank fixed deposits (FDs). She is well aware that due to the safe nature of FDs, the returns on them are low. Yet, she was in for a surprise when she had to renew one of her maturing FD, and could hardly believe that long term FDs were just yielding ~5.0%, the lowest in her lifetime.

What’s happening today has happened before!

Most of us do know that post-Covid, Central Bank action has resulted in a gush of liquidity, which in turn has led to sharp fall in interest rates. Also, it is human tendency to extrapolate the current trend i.e. interest rates will continue to fall. Let’s see if history can offer a different insight:

The above is 17 year history of SBI’s fixed deposit rate which we have analysed in light of the important economic events that have transpired over this period. Few things stand out:

• FD rates decline after major economic events i.e. Global Financial Crisis (2009), Rupee Crisis & Demonetization (2013-16) and Covid response (2020). This can be attributed to Central Bank’s intervention after every crisis, to keep the financial system in good health.

• But once the crisis period was over and economy started to recover, the demand for money as well as interest rates went up (2004-07, 2009-12, 2017-18). Thus, interest rates are never static, they keep fluctuating. Extended period of decline is followed by period of rise and vice-versa.

As we see from the chart, interest rates have steadily declined since 2012, as a result of strong global liquidity and declining economic activity in India. The current backdrop is very similar i.e. there is a lot of systemic liquidity and economic growth too is tepid. However, this wouldn’t be a permanent state of affairs. Economic activity is projected to rebound in 2021-22 and that will increase the demand for money and interest rates could well start inching up.

We can never be sure if the FD rates will go back to good old days of 8-9%, but one thing is reasonably clear – that there isn’t much room for the rates to go down further. Interest rates in USA are already close to 0%; Retail inflation in India has crossed 6%, and it’s only a matter of time that industrial activity picks up. All this should result in rates rising again.

But I need to invest today, what shall I do?

Coming back to Sonali’s problem – one of her long term Bank FD has matured and she is looking to reinvest it back. She wonders if she should opt for long term FD tenure despite the low rates? Our suggestion to Sonali is to park the money in a short term FD (6 to 9 months) even thought they offer lower rates. This will give her the chance to re-invest this money in longer term instruments later in 2021, when rates become better.

Also let us not forget that just a few months before the Covid pandemic hit us, many long term government bonds were yielding 7.5%, AAA rated corporate bonds were yielding 9.0% and tax-free bonds were yielding 6.0%. This opportunity may come up again in the coming quarters, so let’s not lock all our liquidity in long term low yielding instruments at this juncture.

Feel free to reach out in case you need help with your Fixed Income investments.

PS – Name has been changed to protect the identity of the individual.