Time to book profit on NBFC stocks?

Q2 earnings look promising; experts believe high valuations after recent rally limit the risk-reward

If you had bought shares of non-banking financial companies (NBFCs) at the start of 2016, you would have booked at least 10 per cent gains, twice the 5.6 per cent gains of the S&P BSE Sensex this year. NBFC stocks such as Bajaj Finance, Cholamandalam Investment and Finance, Shriram Transport, and Muthoot Finance returned between 35 and 90 per cent this year.

At the beginning of 2016, there was shift in preference from banks to NBFC stocks. Interest rate on bonds coming down helped them reduce their cost of funds. While some fundamentals haven't changed, particularly loan growth and profitability, experts advise caution.

Macquarie cautions that NBFC stocks are like an expanding bubble. "NBFCs have rallied sharply on strong earnings growth delivered at a time when growth is hard to come by. But, at current valuations, the margin of safety is too low," the brokerage wrote in its report. Others including analysts at Religare Capital Markets have a similar opinion. The brokerage, which recently concluded its road show on Indian financial institutions in the US, said in its note: "Most investors agreed with our view that NBFCs are trading at premium valuations compared to their underlying fundamentals." The price-to-book value-based stock valuations of NBFCs are up from 1.5-2x to 2.5x currently. In addition to concerns on valuations, Citi points out that the best part of bond rate (decline) trades are probably done, suggesting that not much of incremental cost advantage may be available for NBFCs going forward.

For housing finance companies, there could be more trouble. Rating agency Ind-Ra points out that delinquency in loan against property (LAP) portfolio could increase in the next four quarters. "Signs of early stress are visible in LAP business, including a sharp rise in 90 days due to delinquencies for some of the large players," it says. Also, if banks (private and public), post strong Q2 results and maintain decent forecast on asset quality, investors may shift preference from NBFC to banks once again, as many of them are also trading at reasonable valuations.

R Sreeshankar, head of research at Prabhudas Lilladher, says it would be unfair to broad-brush the NBFC stocks and book profit across the counter. "NBFCs are very dynamic now and ones like L&T Finance remain a good buy despite the stock run-up as its business will become more focused in the next 24-36 months."