Gold finance stocks doing well, but await correction before investing

A healthy loan growth and asset quality should help protect return on assets, but these may be priced in

Despite the stress non-banking finance companies (NBFCs) are going through, one segment i.e gold financing has remained an outlier. The stocks of two gold finance majors -- Manappuram Finance and Muthoot Finance -- have surged 20-39 per cent in the last three months, outperforming the 10 per cent rise in leading indices such as the BSE Sensex. What is enthusing the Street towards this set of NBFCs is their ability to sustain the strong return ratios amidst a challenging environment.

In the first-half of FY20, i.e April-September 2019, return of assets (RoA) of both these lenders stood at 5.5-8 per cent levels against 5-6 per cent in FY19. Going ahead, the lenders are expected to sustain their healthy ROAs (see graph). ROA, a profitability measure, is a ratio between profit and average assets of a firm.

Factors such as good loan book growth, which would propel interest income, and strong asset quality indicating lower credit cost would help gold financiers to protect RoAs. According to Shubhranshu Mishra, analyst at BOBCAP Securities, “Credit squeeze for micro SMEs (small and medium enterprises) amid NBFC stress, higher gold prices, expansion of the gold financiers in the mass segment, focus of technology, among others are likely to support the lending growth of gold finance companies.”

Figures represent return on assets in % | Source: Companies and Bloomberg

After losing investors' trust post-IL&FS crisis in September last year, funding has become a tough task for many NBFCs. This is auguring well for gold finance companies, which have been able to successfully raise money, given the supportive balance sheet structure. This supportive trend is likely to stay at least for the next one year, believe analysts. However, the lenders’ strategy to increase footprint in the mass segments in some states in the north improves their medium-to-long term growth prospect.

Among the few caveats though is valuation. With the sharp run up, the stocks are currently trading at around 2 times FY21 estimated book value (compared around 1.7 times their long-term historical average and up to 1.5 times in case of many other NBFCs). Thus, a good correction in the stock prices would be a good entry point for investors.