How to analyze microcap NBFC’s?

When analyzing micro-cap NBFCs (Non-Banking Financial Companies) in the secured lending business, especially those in an expansion phase, it’s essential to consider several critical factors that impact both the business’s growth trajectory and the returns for early investors.

Key Dynamics of a Micro-Cap NBFC in Expansion

1. High OPEX/AUM and Subdued ROA/ROE:

   • During the expansion phase, micro-cap NBFCs typically experience high operating expenses relative to their assets under management (AUM). This high OPEX results in a lower Return on Assets (ROA) and, consequently, a subdued Return on Equity (ROE). It takes time for operating leverage to kick in, where fixed costs become a smaller percentage of revenue, improving profitability.

2. High Cost of Funds:

   • As a micro-cap entity, the NBFC might face challenges in securing low-cost funds, impacting Net Interest Margins (NIMs). This limits the leverage the company can utilize since increasing leverage could raise the perceived risk, further increasing the cost of funds.

3. AUM Growth vs. Capital Requirement:

   • AUM growth at a rate of 50% or more is impressive but requires substantial capital. To sustain this growth and maintain a reasonable ROE, the company will likely need to raise fresh capital. This typically involves equity dilution, which, while necessary for growth, impacts existing shareholders by diluting their ownership.

Impact on Early Investors

1. Continuous Equity Dilution:

   • For early investors, the primary concern is equity dilution. As the NBFC raises capital by issuing new shares, existing shareholders’ percentage ownership decreases. This dilution can suppress the per-share value appreciation unless the company’s growth significantly outpaces the dilution.

2. Capital Raising Strategy:

   • The management’s ability to raise equity at a high Price to Book (P/B) multiple is crucial. If the NBFC can consistently raise funds at a premium, the impact of dilution can be mitigated. However, this requires strong market confidence in the management’s ability to execute its growth strategy.

3. Long-Term Value Creation:

   • In such scenarios, an early investor could benefit if the NBFC eventually achieves significant scale. As the company grows, it may secure lower-cost funding, improve its NIMs, and achieve better operating leverage, leading to higher ROE without excessive dilution.

Historical Precedents

Investors have seen similar scenarios in the past with companies like Bajaj Finance, which started as a small-cap NBFC. In its early stages, Bajaj Finance went through several rounds of equity dilution to fund its rapid expansion. However, the company’s management was able to consistently raise capital at high P/B multiples, and as it scaled, its cost of funds decreased, operating leverage improved, and it delivered exponential returns to its shareholders.

Considerations for an Investor

1. Management Quality and Strategy:

   • Assessing the management’s ability to raise funds at attractive valuations is critical. This includes evaluating their track record in capital allocation, strategic decisions, and execution.

2. Timing and Market Conditions:

   • The timing of capital raises and market conditions play a significant role. Raising capital during favorable market conditions at high multiples can be less dilutive than during downturns.

3. Long-Term Perspective:

   • An early investor in such a micro-cap NBFC should have a long-term investment horizon, understanding that initial returns may be subdued due to dilution, but potential multibagger returns could materialize as the company scales and operating leverage kicks in.

4. Valuation Discipline:

   • It’s crucial to invest at reasonable valuations, considering the potential dilution and the time it might take for the company to achieve scale.

Conclusion

While continuous dilution is a concern, it doesn’t necessarily preclude a micro-cap NBFC from becoming a multibagger. The key lies in the management’s ability to efficiently utilize the raised capital to drive growth, improve margins, and eventually enhance ROE as the company scales. Historical examples show that early dilution, when managed well, can lead to significant long-term gains for early investors. However, investors need to be patient, monitor the company’s progress, and remain confident in the management’s strategy.

Investing in such companies requires a nuanced understanding of the business, a long-term commitment, and trust in the management’s ability to execute its growth strategy while managing dilution effectively.