Microfinance mysteries – buy bare, sell slightly better

The ideal time to sell is when conditions appear flawless—when the business stabilizes, management exudes confidence, sell-side analysts are optimistic, and forward estimates look exceedingly positive.

Imagine a woman in a rural Indian village, barely surviving on subsistence farming. With a modest microloan, she buys a goat—a simple decision that transforms her life. The goat provides milk to sell, generating a steady income. Over time, it births kids, growing her herd into a sustainable enterprise. Manure enriches her crops, boosting yields, while profits send her children to school. What began as a single loan ripples outward, uplifting her family and invigorating the local economy. This is the transformative power of microfinance: small investments unlock boundless potential.

This is the story Vikram Akula shares in Micro-Meltdown, chronicling the rise, fall, and revival of SKS Microfinance, once the world’s most valuable microlender.

Shares of microfinance lenders in India have recently experienced significant declines amid rising levels of non-performing loans. For instance, CreditAccess Grameen and Satin Creditcare have each fallen approximately 50 percent from their recent peaks, Spandana Sphoorty has declined by around 70 percent, and Fusion Finance has plummeted  75 percent. Notably, in all these cases, the recent highs were achieved within the current calendar year, 2024. In this light, revisiting Vikram Akula's book proved to be particularly intriguing.

This raises two key questions: (a) Why are microfinance businesses so deeply cyclical? and (b) Are they investable, and if so, how should they be valued? This article explores these critical issues.

Why are microfinance businesses so deeply cyclical?

Founded by Vikram Akula in 1997 in Hyderabad, SKS Microfinance began as a non-profit before transitioning to a for-profit model in 2005 to enable scalability and attract investment. It went public with a stock exchange listing in August 2010.

The cyclicality of microfinance is evident in SKS Microfinance's trajectory. From 2005 to 2011, it earned cumulative post-tax profits of Rs 4 billion but reported a staggering loss of Rs 13.6 billion in 2012 due to the Andhra Pradesh microfinance crisis. This crisis, fuelled by stringent regulations and worsening recoveries, crippled asset quality and necessitated substantial provisions. Vikram Akula left in November 2011 (as detailed in Chapter 22 of Micro-Meltdown), and the company was later acquired by IndusInd Bank in 2017.

Firstly, cyclicality is deeply rooted in the contentious question of whether microfinance should operate as a for-profit entity. Vikram argues that a for-profit model attracts capital, drives efficiency, and scales impact. However, it risks borrower exploitation through high interest rates and aggressive recovery practices, as seen during the SKS backlash. Mission drift and over-commercialisation further threaten public trust, with stakeholders perceiving profits as overtaking the mission of poverty alleviation. The SKS crisis also saw external forces intensify the backlash—politicians protecting government-run self-help groups (SHGs), traditional moneylenders, NGOs, and sensational media coverage all played a role in eroding confidence in microfinance. Balancing profitability with financial inclusion remains a significant challenge.

Secondly, losses tend to cluster during periods of agrarian stress, whether triggered by natural disasters, social unrest, or underlying vulnerabilities. Limited financial literacy among borrowers often leads to inadequate understanding of sustainable borrowing levels. Additionally, the moral hazard created by political promises, such as loan waiver schemes during election years, further exacerbates the likelihood of widespread defaults.

Are they investable, and if so, how should they be valued?

The essence of fund management used to lie in identifying companies that deliver sustainable profits and robust returns over time. Historically, the belief that such companies are always great investments was shaped by market behaviour in India from the early 2000s to the pre-COVID era, reinforced by increasing foreign ownership. However, since COVID, the rise in retail participation has brought market cycles into sharper focus—a trend likely to endure.

The key shift required is a change in mindset: recognising that it is not only great companies that can make great investments, but so-called "bad" companies  which can also yield significant returns under the right conditions. Embracing the permanence of cycles allows microfinance businesses to emerge as compelling opportunities, albeit with necessary adjustments.

Microfinance stocks have demonstrated impressive short-term returns. CreditAccess shares more than tripled twice in the past five years (Oct 2018–Feb 2020, Apr 2020–Jan 2024), Spandana shares nearly tripled (Jun 2022–Jan 2024), and Satin’s shares almost quintupled (May 2020–Jan 2024).

The investment strategy for microfinance stocks hinges on timing: they become attractive when conditions have been dire for an extended period, and the management shows signs of capitulation. Key indicators include rising external pressures from delinquencies, political moral hazards, increasing NPAs, and a desperate need for capital at any cost. The ideal entry point is when hope is nearly extinguished—marked by management changes, ownership restructuring, sombre conference calls, and widespread sell-side pessimism.

The key to a successful trade lies in knowing when to exit, which can seem counterintuitive. The ideal time to sell is when conditions appear flawless—when the business stabilises, management exudes confidence, sell-side analysts are optimistic, and forward estimates look exceedingly positive.

Buying a business when all seems lost and selling it when all seems perfect is easier said than done, especially as these moments often span years apart. Why not avoid such businesses entirely? Because the world is increasingly cyclical—a point I’ve elaborated on extensively in other articles before. If we must navigate cycles, why shy away from those that are inherently more cyclical and offer unique opportunities?