Investors in India’s Non-Banking Financial Companies (NBFCs) should adopt a more selective approach as the sector’s historical earnings advantage over traditional banks diminishes, according to Viral Shah, Senior Vice President, Equity Research at IIFL Capital.
Shah’s assessment, shared at the IIFL Investor Summit, centers on converging valuations, narrowing earnings premiums, and emerging margin risks within the NBFC landscape. He indicated that a shift in strategy is warranted, advising clients to be “a bit more selective” regarding NBFC investments.
Valuations are a primary concern. NBFC valuations currently align with long-term averages, and some are trading at a premium, justified by superior earnings growth, Shah noted. However, he anticipates this earnings premium relative to banks will decrease as public sector and private banks experience an inflection point in their own earnings growth. 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.
Margin risk is likewise a significant factor. Despite a 125 basis point reduction in interest rates, yields on NBFC paper rated below AAA have remained stagnant for the past year and a half. This differentiation extends even within AAA-rated and corporate-backed NBFCs, indicating a complex landscape where cost of funds isn’t uniformly decreasing. Shah highlighted that while NBFCs have benefited from lower bank borrowing costs, higher market borrowing costs are offsetting these gains, potentially leading to earnings cuts.
Shah recommends focusing on NBFCs that are diversified and possess relative advantages on the liability side, such as strong parentage or credit ratings. “They seem better placed and will deliver stabler earnings growth over a longer period of time,” he said.
The rise of digital lending platforms, including entrants like Airtel and Jio, is expected to reshape the NBFC landscape over the next three to five years. While these newer players have a potential advantage in digital distribution and liability management, Shah believes execution will be gradual. He pointed to Jio Finance, which took three years to reach a ₹20,000 crore loan book, suggesting that immediate disruption to larger players is unlikely. Competitive intensity will increase, but larger, more diversified players have levers to offset digital competition.
Shah acknowledged that high valuations for NBFCs are partly justified by their lending growth, but cautioned that rationalization may occur as digital lending becomes more mainstream. However, he suggested that even with some compression in valuations, investors could still expect decent returns – a 18-20% CAGR – from larger NBFCs delivering 20-25% earnings growth.
He also observed that valuation resets are sometimes necessary when earnings growth slows, citing Chola Finance as an example of a stock that was materially below current levels a year ago, despite the underlying business remaining intact.