Tej Shah of Marcellus explains why betting on financials could be a wealth creating opportunity

Tej Shah, Portfolio Manager at Marcellus Investment Managers, who oversees Kings of Capital PMS, expects 3x rise in financial assets from $500 billion to $1.5 trillion over the next decade.

Shah comes from a family of Chartered Accountants where dinner table conversations used to be around balance sheets and cash flow statements.

Q) A brief about yourself. What have you done in terms of education and when did your love for equities started?

A) I am a part of the investment management team of Marcellus and cover the financial services sector. Prior to joining Marcellus, I worked at Mayfield, a Silicon Valley headquartered venture capital fund that manages $3billion globally and $220 million in India. Prior to Mayfield, I was a part of the equity and capital markets team of Ambit Capital where I worked on executing IPOs, QIPs, and buybacks.

I am a chartered accountant and have cleared levels of the CFA exam. I come from a family of chartered accountants where dinner table conversations used to be around balance sheets and cash flow statements and that is one of the reasons why I got interested in finance and equities at an early age.

Q) A PMS for the financial sectors – Kings of Capital. A unique way to approach it. So what is the strategy you follow in the PMS?

A) Over the past 5-6 years, India’s Financial Services sector has been hammered by corporate NPAs, demonetisation, the ILFS crisis, and now the COVID crisis, this has put extreme pressure on the weaker lenders.

However, we looked back to the global financial crisis and the NBFC crisis of the late 90s and saw that investing in high-quality financial stocks during a crisis proves to be highly rewarding.

For example, if you had invested in the Bank Nifty when it bottomed out during the Lehman crisis, your five years compounded return would have been 28 percent.

Even if you had invested three months prior to the bottom, your five-year return would still have been a very respectable 21 percent.

The key objective of our Kings of Capital strategy is to own a portfolio of 10 to 14 high-quality financial companies (banks, NBFCs, life insurers, general insurers, asset managers, brokers) that have good corporate governance, prudent capital allocation and high barriers to entry.

About 60 percent of the fund is currently invested in lenders i.e. banks and NBFCs and about 40 percent of the fund is invested in leading life insurers, general insurers, asset managers, and wealth managers.

By owning these high-quality financial companies, we intend to benefit from the consolidation in the lending sector and the financialization of household savings over the next decade.

Q) What is the investment philosophy (mantras) you follow when making a buying or a selling decision?

A) The three tenets for selecting stocks in Kings of Capital remain the same as in our previous two strategies – Consistent Compounders and Little Champs:

Clean accounting and good corporate governance; Historical evidence of prudent capital allocation; and High barriers to entry so that companies are able to sustainably generate a return on equity higher than the cost of equity.

Given the inherently leveraged business models of financial services companies, the importance of each of these traits is further amplified and therefore we believe we can put our skills around forensic accounting and understanding barriers to entry to good use to create a portfolio of high-quality financial services stocks.

We stay invested in such businesses for long periods of time and let compounding work its own magic. We have seen the sort of wealth that well-run lenders like HDFC Bank, Kotak Mahindra Bank or Bajaj Finance can create over a long period of time.

We decide to exit from such high-quality names only if we believe that the business is faltering on any of these fundamental aspects of governance, capital allocation or building competitive advantages.

Q) What is your outlook on the financial sector? We have seen a lot of volatility already, and the government is doing what it can to boost investments and kickstart the economy. The financial sector is the front runner of any such boom. What are your views?

A) We are likely to see massive consolidation in the financial sector. Even after over 20 years of the likes of HDFC Bank or Kotak Mahindra Bank growing at a 20%+ CAGR, private banks only have a 35% market share.

The pace at which the private banks gain market share from the PSU banks is going to accelerate at a rapid pace because of COVID and the biggest beneficiaries of this shift will be the well-capitalised private sector banks and NBFCs.

For example, HDFC Bank only has a 7 percent market share and Kotak Bank only has a 1.5 percent market share in the lending industry. The market share of these private banks can easily double and that will translate into a 20%+ loan book CAGR over the next few years.

We saw something similar play out in the aftermath of the 2008-09 global financial crisis as well as the NBFC crisis of the late 90s.

The great lenders benefit post a crisis because (a) when the competition struggles to raise funds during & after a crisis, great lenders have access to adequate liquidity; and (b) as competition’s ability to lend reduces, great lenders can pick and choose quality borrowers, leading to better net interest margins, higher loan book growth, lower NPAs and hence better RoEs.

While the short term is always volatile, share price movement in the long term is driven by earnings growth. The data that we have crunched suggests that shareholders of great lenders are more than compensated for taking the volatility inherent in financial stocks by way of higher returns i.e. the Sharpe ratios of great lenders are much higher than other great non-financial companies.

Q) One of the unusual features of Kings of Capital is that 40% of your fund is invested to Financial Services companies that are NOT involved in lending. What led you to allocate such a high weight to non-lenders?

A) As per the RBI’s 2017 Household Finance Committee report, 95% of Indian household wealth is in the form of physical assets i.e. gold and real estate while only 5% is in financial assets. What this implies is, of India’s $10 trillion household wealth, $9.5 trillion is in physical assets and only $500Bn is in financial assets.

Most other global economies at our stage of development have a 85:15 sort of mix (85% in physical assets and 15% in financial assets).

Even if we conservatively assume that India’s total wealth remains constant over the next decade, a shift of 10% over the next 10 years from physical assets to financial assets will add $100Bn to financial savings each year.

This implies a 3x rise in financial assets from $500Bn to $1.5 trillion over the next decade. This money will flow into direct equities, mutual funds, life insurance and general insurance.

We have invested in the leading players in these sectors to benefit from this massive opportunity. Investors did not have the opportunity to invest in these businesses till about three years ago and the listed Financial Services universe was dominated by banks and NBFCs.

However, because many insurers, asset managers and brokers have become available to public equity investors in the past 2-3 years, we have been able to create a portfolio where we benefit from not only the consolidation of the lending industry but also from the financialization of household savings.

These non-lending financial companies are in some way at a similar stage to where the banks and NBFCs were in the early 2000s and have a long runway for growth.

Q) How can investors invest in this fund? What is the fee structure which the fund follows?

A) We offer the Kings of Capital Portfolio in a PMS construct. Kings of Capital Portfolio investors can choose from the following two options – (i) a fixed fee of 2.5% per annum with no performance fees or (ii) a 1.5% per annum fixed fee and a performance fee of 15% profit share over a 10% hurdle without catch up.

Disclaimer - Marcellus owns HDFC Bank, Kotak Bank and Bajaj Finance in several of its portfolios. The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.