India’s NBFC Sector: A Shift Towards Selective Investment

India’s Non-Banking Financial Companies (NBFCs) are at a pivotal juncture, demanding a more discerning approach from investors as the historical earnings advantage over traditional banks diminishes. Experts are now advising selectivity, emphasizing the importance of digital readiness and long-term earnings stability in a rapidly evolving financial landscape.

The Narrowing Earnings Premium

For years, NBFCs have enjoyed premium valuations fueled by superior growth rates. However, as both public sector and private banks demonstrate improving earnings, this advantage is eroding. According to Viral Shah, Senior Vice President at IIFL Capital, investors need to be “a bit more selective” regarding NBFC investments. Current valuations are already at long-term averages, and some are trading at a premium, justified by earnings growth, but this may not be sustainable if growth slows.

Shah notes that while larger NBFCs are still projected to achieve a Compound Annual Growth Rate (CAGR) of around 25% over the next two years, the gap is closing as banks, including Public Sector Units (PSUs), are set to experience an inflection point in their earnings growth. This shrinking relative earnings premium is a key factor driving the need for increased selectivity.

Margin Pressures and Cost of Funds

The narrowing earnings premium isn’t the only challenge facing NBFCs. Despite recent interest rate reductions of 125 basis points, yields on lower-rated NBFC paper have remained stagnant for the past year and a half. Even highly-rated NBFCs are grappling with a complex cost of funds situation. While lower bank borrowing costs are beneficial, they are being offset by higher market borrowing costs, potentially leading to earnings cuts.

Shah highlights that a reduction in the cost of funds due to repo rate cuts may not fully materialize, further exacerbating margin pressures.

Focus on Diversification and Financial Strength

In this evolving environment, Shah recommends prioritizing NBFCs that are diversified and possess relative advantages on the liability side, such as strong parentage or high credit ratings. These companies “seem better placed and will deliver stabler earnings growth over a longer period of time.”

Digital Lending and Competitive Landscape

The NBFC landscape is expected to be reshaped by digital lending over the next three to five years, with new entrants like Airtel and Jio entering the market alongside established players like Bajaj Finance. While these newer entrants have a potential advantage in digital distribution and liability management, Shah believes execution will be gradual.

He points to Jio Finance, which took three years to reach a ₹20,000 crore loan book on the NBFC side, suggesting that the impact on larger players will be gradual. Competitive intensity will increase, but larger, more diversified players have levers to offset digital competition.

Valuation Reset and Market Patience

Valuations remain a critical consideration. While high valuations for NBFCs are currently supported by lending growth, rationalization may occur as digital lending becomes more mainstream. However, Shah suggests that even with some compression in valuations, investors can still expect decent returns – around 18-20% CAGR – from larger NBFCs delivering 20-25% earnings growth.

Shah also emphasizes the importance of market patience, noting that valuation resets are sometimes necessary when earnings growth slows. He uses Chola Finance as an example, pointing out that its stock was significantly below current levels a year ago, but the underlying business fundamentals remained intact.

Key Takeaways

• Investors should adopt a more selective approach to NBFC investments.
• The earnings premium of NBFCs relative to banks is narrowing.
• Margin pressures and the cost of funds are key risks.
• Diversified NBFCs with strong financial backing are more resilient.
• Digital lending will reshape the landscape, but the impact on larger players will be gradual.

As NBFCs navigate this changing financial landscape, selectivity, digital readiness, and a focus on long-term earnings stability are paramount for investors. A careful and discerning approach will be crucial to identifying opportunities and mitigating risks in this dynamic sector.