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People often look at stocks as just tickers and numbers. When a stock goes up by 20%, they expect it to correct and often end up booking losses when they short sell a security. This happens primarily because they don’t understand the business and think of a stock as a sole collection of numbers. How to avoid this mistake? Go through this detailed article to find out!

A Fallen Star

Coming from a Chemical Engineering & MBA (Finance) background, Financial Services (BFSI) and Oil & Gas industry have been 2 of my top choices for my valuation models and investing. Following Warren Buffett’s advice – “You should only invest in businesses which you fully understand”, one of my favorite Banking stocks since 2018 has been AU Small Finance Bank. With healthy financials and competent management, it had exhibited a consistent rally till early 2020.

Fig 1: AU Small Finance Bank doubling from Jan, 2018 to Jan, 2020

However, this rally came to a halt as COVID-19 made its toll evident on global markets. Concerned over a rise in loan defaults (NPA), the entire banking sector crashed fueled by panic selling from FII(s), DII(s) as well as retail investors.

Fig 2: Bloodbath in Banking sector due to COVID-19

As evident from Fig 2, the entire banking sector was a mess. One of the strongest banking stocks HDFC Bank was down by 25% within a month. The most popular banking index Bank Nifty had eroded by a shocking 37% but the biggest shock which I received was seeing AU Small Finance Bank down by almost 60% in a month. Was this justified or was this an opportunity to exploit?

A ‘Fundamental’ problem?

Remember I started this article with a classic quote from Warren Buffett – now I’ll tell you why it’s so important to understand the business where you put your hard-earned money into. What’s the difference between a normal commercial bank like HDFC or SBI and a Small finance bank (SFB) like AU?

While a large bank like HDFC has well-established roots in urban markets lending to big corporates like Reliance, a SFB aims at increasing Financial inclusion. It’ll lend to a small-scale business in the suburbs like Fresh Veggies which buys produce from farmers in bulk, washes, peels and packs them into containers and sells those to the busy urban population who don’t have time to perform all these steps. Now you might ask, how does this explain why AU fell by 60%?

The answer to the above question is ‘Trust & Reputation’. Imagine that you’re a moneylender who’s been approached by 2 businessmen – the first one with a reputation of always paying back on time while the 2nd businessman has set up his shop just a year before. Who are you more comfortable with while lending your money? Add to this a raging pandemic with economy coming to a standstill, would you trust a veteran with good credit history or a business newbie with your money? This translated to a severe concern over AU’s loan book which primarily composed of clients like the 2nd businessman in our example. So, what did AU’s management do?

Fig 3: Bracing for impact

AU had a consistent rise in Earnings (QoQ) and an increasing Operating Profit before Provisions & Contingencies (OPPC), which is one of the most significant metric on a bank’s income statement. Anticipating a rise in NPAs, AU tripled its Provisions in order to write-down profits in lieu of anticipatory (future potential) losses. Inspite of this conservative approach, it still ended Q4 with a 122 cr. profit unlike many other banks whose Q4 ended in red.

A Diamond in the Rough

Now, SFBs are assumed to be riskier because a major chunk of their loan book belongs to unrated companies. Even large banks like PNB & SBI have faced huge setbacks when high rated companies like IL&FS, Essar Steel defaulted, so my mindset was clear – “How does AU’s NPA numbers fare in comparison to others (large banks, SFB peers etc.)?”

Fig 4: Gross NPA levels of sample banks
Fig 5: Net NPA levels of sample banks

As expected, HDFC Bank came out on top with negligible NPA levels while SBI showed concerning insights. Inspite of being a SFB, AU’s management had been extremely careful with loan approvals (Gross NPA near 2% & Net NPA around 1%). The bank wasn’t under any immediate stress, still it was prudent with a 34% NPA provisioning against the average provisioning of 15%. I knew that some of this excess provisioning would be reversed in the coming quarters, which would increase its NPM (Net Profit Margin) & thereby share price.

My Investment Rationale

 Mar ’20Mar ’19Mar ’18
FII holding32.14%29.06%26.89%
ROCE12.73%11.87%11.71%
ROE18.56%14.66%13.76%
Table 1: Key numbers to watch

One of the crucial aspects to examine before choosing any stock as a long term bet is its Shareholding pattern. A few inferences are as follows:

  1. Never invest major chunk of your portfolio in a stock where promoter holding is exorbitantly high (>70%): A few bulk deals can make or break such stocks.
  2. Always observe FII sentiment w.r.t a stock: A substantial FII shareholding automatically filters out a lot of stock market weeds. A Sovereign or Pension fund would never invest in companies with poor corporate governance & narrowing margins.
  3. Watch out for ROCE & ROE: Just like you’re looking to increase returns on your capital, a good company always searches ways to add more value to its reserves. How can you expect 15% p.a. return from a company’s stock in the long run if it itself generates a 5% return on capital? Always look for companies with ROCE>10% and ROE>12-14% if you want a 12-15% return in the long run.

AU SFB perfectly satisfied my criteria and with no fundamental weakness, it was definitely oversold. Thus began my hunt for accumulating this mispriced gemstone.

The Art of Investing

Before moving to my journey, let’s bust a common myth – When a stock falls from 1000 to 400 and corrects to 700, many people think – “I could’ve made 75% return if I’d bought it at 400”. Although it sounds nice, it’s almost impossible to catch the bottom. I’ve made much more wealth in the last 5 years by giving time in the market than madly trying to time the market. AU’s case was no different.

Fig 6: AU SFB near its bottom in May, 2020

When AU hit its bottom of appx. 400 in mid-May, I wasn’t dumping all my money into AU, rather I was increasing my indirect exposure to AU through Mutual funds. In July, I was holding a few hundred shares but the main boost came when I launched the SG Consultants Smart Returns Fund (SRF). It was only in mid-September when I was holding 2,600-odd shares of AU at an average cost of 644.

Fig 7: AU SFB during launch of SRF portfolio

While managing the SRF portfolio from Sep, 2020 to Jan, 2021, AU proved to be an absolute star. I finally exited my fund holdings at an average of 920 a week prior to Christmas though I’ve continued to hold it in my personal investment portfolio through Mutual funds.

Fig 8: AU SFB during Fund redemption

As of today (2nd week of Sep, 2021), AU has risen to 1,200-odd levels, partially fueled by the bull market worldwide. With a strong business model in place with millions of India still excluded from the banking ecosystem and digital banking helping banks reduce their costs, I believe AU still has got some steam left before it consolidates around the 1,000 – 1,200 mark.

Disclaimer: All research & analysis presented in this article is my own and not a recommendation to buy, sell or hold any particular stock. Every investor should carry out his/her own analysis before investing his/her hard-earned money in any instrument.

Sayantan Ghosh

MBA (Finance), FMVA®