In the world of financial institutions, a quote from Warren Buffett resonates profoundly: “The key to financial institutions is having the lowest-cost operation and the trust of the public.” This principle, though universal, takes on particular significance in the Indian financial ecosystem, where trust and disciplined lending practices have become key differentiators in determining long-term success and valuations.
Indian financial institutions such as HDFC Bank and Kotak Mahindra Bank have consistently demonstrated disciplined, high-quality lending practices over the years. These institutions have built a reputation for prudent credit decisions and strong asset quality. However, current valuations in the market do not fully reflect the superiority of these practices. This disconnect, we believe, is temporary. As the broader market begins to differentiate more sharply between good and bad lenders, institutions with a track record of superior lending practices are likely to witness some re-rating and attract better than current valuation multiples.
Credit Growth vs. Asset Quality: Striking the Right Balance
The allure of rapid credit growth often tempts financial institutions to compromise on asset quality. However, credit is inherently easy to distribute—it’s in ensuring that it is prudently deployed that true expertise lies. Reckless credit growth, while offering short-term gains, almost always comes at the cost of long-term sustainability. There’s little value in growth if it leads to a deterioration in asset quality, eroding not only profits but also trust, the cornerstone of financial institutions.
The Indian financial sector has witnessed repeated cycles where aggressive lending, especially during periods of economic optimism, resulted in significant non-performing assets (NPAs). The lessons from these cycles are clear: institutions that prioritize asset quality over sheer growth are better positioned to weather downturns and sustain long-term profitability.
Emerging Opportunities in the Lending Space
Certain segments within the secured lending space are beginning to look particularly interesting. Housing finance players backed by public companies, for instance, stand out. Despite strong demand predictability in this space, valuations for some of these players remain close to book value, offering significant potential for upside in case of growth triggers playing out. Similarly, some non-banking financial companies (NBFCs) in the auto sector have been severely penalized in valuations due to asset quality concerns that are primarily a reflection of the payables cycle, rather than fundamental weakness. These are opportunities where the risk-reward dynamic appears increasingly attractive.
Conversely, we still remain cautious about unsecured credit. While certain pockets of the market offer excellent valuations, we believe these cycles take time to turn. It is often better to wait for clear signs of stabilization rather than attempting to pick the bottom prematurely.
Interesting themes are also emerging in areas like affordable housing, developer finance, and credit cards. These sectors, viewed with skepticism till recently, are now seeing reduced competition and a turnaround in the asset quality cycle, as evidenced by improvements in the NPA stage buckets. This evolution presents a unique opportunity for investors willing to focus on overlooked but fundamentally strong propositions.
Safety Over Return, But Time is Ripe
In the world of highly leveraged businesses, prioritizing safety over return has always been paramount. The risks associated with poor asset quality, cyclical downturns, and reckless growth are too great to ignore. However, we believe the time is now ripe for safety and quality to be increasingly recognized and rewarded by the markets.
The divergence between good and bad lenders will only grow sharper, and institutions that embody discipline and trust in their lending practices are positioned to emerge as clear winners. For investors, the focus must remain on identifying these opportunities, where quality lending meets favorable valuations, to capitalize on the market’s eventual recognition of these traits.
