HDFC Bank and HDFC Limited have been a core part of our portfolios for several years and both fit perfectly with the criteria that we look for in great companies – predictable and consistent growth, large addressable market opportunity, highly profitable and well managed. Earlier this month, it was announced that HDFC Limited will merge with HDFC Bank. HDFC Limited shareholders will get 42 shares of HDFC Bank for every 25 shares held. The final merger, if approved, will take 12-18 months to be completed as there are multiple regulatory approvals required. Given the implications, we thought it would be an appropriate time to analyze the merger, its implications and the core thesis for the investment itself.

The Indian banking industry, as measured by its total asset base, has been growing at 10.6% p.a. over the past decade – slightly above nominal GDP growth rate of 10.0% p.a. Private banks have been growing at a much higher rate of 16.5% p.a. over the same period. HDFC Bank has been growing at an even higher rate of 20.2% p.a. over the same period. Market share of private banks has increased from 19.5% to 32.8% over the past decade and the public sector banks have steadily lost market share. HDFC Bank has increased its share from 3.9% to 8.9% in the same period. Given these trends, it is expected that the banking growth will continue in India for the next several years, as banking penetration relative to GDP is still significantly lower than global averages. Private banks should continue to gain share and HDFC Bank should continue its relative share gains due to its strong franchise and risk management systems built over time.

A bank typically lends to both businesses and individuals. One of the largest pool of demand for loans is the home loan segment to individuals. Adjusted for the risk, it is a highly profitable segment and the repayment period is long, leading to a stable loan base. Home loan-to-GDP ratio in India is only about 11.4%, whereas the corresponding number in developed markets averages 40-80%. When HDFC Bank was originally incorporated 1994, it was agreed that HDFC Bank will not get into the home loan segment as the business conflicts with its parent’s business. HDFC Bank sources home loans for HDFC Limited and is also allowed to purchase a certain proportion of these loans. With HDFC Bank emerging as a dominant bank in India, it can continue to grow above industry by having access to the home loan market. Mortgage linked loans as a proportion of total advances for HDFC Bank was just 10.5% compared with 33.2% for ICICI Bank and 19.8% for SBI.

On the other side, HDFC Limited which is a pioneer in the mortgage business had a slight disadvantage due to higher cost of borrowing compared with the banks, as it was dependent on wholesale borrowing. Banks offer current and savings accounts to their customers, where the interest rate paid out is lower than fixed deposits and wholesale borrowing, leading to a lower overall cost of borrowing. With the merger, the advantages are clear – HDFC Bank will be able to lend to the home loan market and cross-sell banking products and services to the larger, combined customer base, using a lower cost of funds than HDFC Limited.

From a shareholder perspective, HDFC Bank has delivered a 23.0% p.a. stock price return over the past 20 years, which is 63x the original capital and so did HDFC Limited, with a 19.3% p.a., delivering significantly better returns than the Nifty at 14.8% pa. These returns are also in line with the underlying growth in these businesses. In terms of future prospects, given the underpenetrated nature of banking in India, private sector banks increasing its share and HDFC Bank being in an even better position post the merger, future growth prospects look very attractive.

Shareholder experience in the short term has been very different from the long term picture. Over the past 2 years, the Nifty has delivered a 31.7% p.a. return compared with 17.6% for HDFC Bank and 7.9% for HDFC Limited. HDFC Bank did face several internal pressures. RBI had clamped down on any new issue of credit cards till certain control systems were put in place. There were restrictions on opening current accounts with firms which had a loan with another bank. The explosion in use of UPI led to high levels of failures. There is also an increased regulatory oversight. HDFC Limited was also facing increased competitive pressures from other banks. We believe most of these regulatory and technology related issues have been fixed. The merger also addresses the competitive pressure faced by HDFC Limited. Despite these pressures, HDFC Bank has grown at nearly 18-20% and HDFC Limited at about 12% over the past 12 months.

At current prices, HDFC Bank trades at close to 17x forward price-to-earnings which is much lower that its historical average of 22x. For most of the past 20 years, HDFC Bank has traded at a premium to the market whereas it is currently trading at a discount to the Nifty PE of 22x. One of the main reasons for this discount is the incessant FPI selling since October 2021. Of nearly Rs. 272,000 crores, a significant majority came from the BFSI sector. Never in the Indian stock market history have we seen such huge selling. Both HDFC Bank and HDFC have faced the brunt of this selling. Both stocks also went up sharply on the day of the announcement, but gave up all the gains. In the short term the cumulative holding in both these stocks has become disproportionately large for many institutional investors. HDFC Bank and HDFC Limited respectively account for 8.5% and 5.7% of the weight in the Nifty. Post-merger, their cumulative weight in Nifty will be closer to 12%, but as per Mutual Fund regulations a fund can’t hold more than 10% in a single stock. Merger of 2 entities also has short term implications on some other indices.

In the long term, stock market return from individual stocks depends on the earnings growth that the company can generate and the absolute valuations at which the stock trades. Even prior to the merger announcement, both the companies were on a strong growth trajectory with one of the best in class balance sheets in the sector. The merger will benefit both businesses in the long term. The stocks are also trading at a discount to both the market and their own historical valuations. The stock price weakness does seem temporary – especially given the spectacular track record over decades. Given the size of the holdings, one may need to fine tune the overall holding over time, but we have time to rebalance and till then both growth and valuations are in our favor.

We have been talking about the rising inflation globally in our prior newsletters and we would like to talk a little more about that. The latest inflation reading for the month of February 2022 in the US came in at 7.9% – there has been a relentless rise in reported inflation in the US with each tick coming higher than the previous month. Inflation in the US, UK and Europe are at multi decade highs. While there has been some impact on inflation because of supply bottlenecks, there has also been a substantial rise in price of global commodities over the last 12 months.

The CRB Commodity Index is an index of 19 commodities and acts as a representative indicator of global commodity markets. Below is its long tail data going back 25 years or so.

There has been a sharp rise in commodity prices over the last 12 months as lockdowns have eased globally and the economy is heading to a more normal trajectory. Below are the 12-month changes in select commodities over the last 12 months.

 

Commodity price change	12 months
Brent Crude	68.5%
Gold	13.1%
Aluminium	61.6%
Copper	17.9%
Cotton	74.5%
Sugar	31.1%
Wheat	66.9%

As can be seen from the chart of the CRB Commodity Index, we have seen two large spikes in commodity prices over the last 25 years – the previous episode was around 2010 and in the current episode, the index has crossed its prior 2010 high. Some observers have commented that the rise in energy prices as well as in industrial metals are linked to the phenomenon of “greenflation”. This term refers to the rise in inflation in certain commodities because of a lack of investment over the last several years in these sectors due to ESG (Environmental, Social and Governance) concerns. Food prices too are at multi year highs and some analysts have said that this could be an impact of climate change on production of these commodities.

It is perhaps no coincidence that the big rise in the CRB index on both occasions (ie 2010 and now) has happened after a heady dose of “money printing” or quantitative easing (QE) done by the global central banks in response to a crisis. In 2008-09 the QE was done to fight the global banking crisis and this time it was done in response to covid. The US Fed’s balance sheet is approximately $8 trillion now and most of the large global central banks have done their version of quantitative easing in their battle against the covid crisis.

What has perhaps further fuelled inflation in commodities is the large stimulus given by governments around the world on the fiscal side to soften the impact of covid and the related lockdowns on the lives of people. In a world where fiat money is supplied in ever increasing quantities to combat a crisis, it is perhaps natural that things which are limited in supply (such as commodities) will go up with reference to the fiat money.

The underlying strength in commodities over the last 12 months was further aided by the war in Ukraine as the West has imposed harsh sanctions on Russia because of its invasion of Ukraine. Russia is a key producer of several commodities, especially oil, natural gas and wheat. Towards the end of March 2022, there was some progress in the peace talks between Ukraine and Russia and there was a resultant fall in commodity prices. One hopes that the peace talks will gain further momentum in the days to come.

Inflation affects the economy in two ways – one is that it reduces the purchasing power of the consumer to consume goods and services, as their incomes are typically not growing at the same rate as inflation. For individual companies, the effects of inflation may vary – companies which have a strong competitive edge or moat, will be able to pass on the inflation in their inputs, to their customers – companies with a weak competitive advantage, may struggle to do the same.

The second impact of inflation is that it forces central banks to raise interest rates in an effort to fight inflation and inflationary expectations. This affects demand in the interest rate sensitive sectors of the economy. The US Fed has raised the Fed funds rate (the rate at which it lends to banks) by 25 basis points at its latest policy meeting and has indicated 6 similar increases in 2022. Many analysts are commenting that the Fed is behind the curve in raising rates as inflation spikes – the US 10 year bond yield has risen by about 100 basis points since October 2021. A corollary impact of rising interest rates, is that it affects the valuation of companies because interest rate is in the denominator in the calculation of intrinsic value of a company.

We are mostly invested in companies with a strong competitive edge and these businesses should largely be able to pass on the input cost inflation to their customers over time. We have also cut down our positions or exited completely the companies which were trading at the higher end of their valuation ranges. We therefore feel that the portfolio is well positioned to ride out the inflation related uncertainties that may unfold.

The news over the last few weeks has been all about Ukraine as the US government warned that Russia was planning to invade Ukraine – equity markets were volatile going into the event and fell violently when Russia did actually invade Ukraine. Subsequently there has been some recovery. While the market ostensibly fell because of the Russian invasion, it is quite possible that the real reason for the market weakness is the very high inflation globally, which is something we discussed in our last newsletter as well.

When we analyse the events of the last few years in India we see that growth in India has been sub-par for several years – the economic cycle seems to have peaked out some time in 2012 post which we had all the scams unfolding under the UPA government. Since then there has been the odd year in between when we have seen decent growth, but disruptions like demonetization, GST and the ILFS crisis have kept growth pegged back for several years. To top it all, came covid which has been a huge disruption, particularly for the poorer sections of society. As we have emerged from covid over the last year, corporate numbers have been encouraging but it is perhaps too early to call whether the economic cycle has finally turned around.

Results for the December 2021 quarter continued to be robust. For the non-financials in the BSE500, we find that the 2-year CAGR for revenues is 14.9% for the aggregate and 12.0% for the median company, which is in line with long term historical trends. EBIT has grown at a 24.3% 2-year CAGR and for the median company the number is 13.1%. The material sector is a heavy contributor to these good results because of high commodity prices in the recent past. If we exclude the material sector, the 2-year CAGR of revenues is 13.3% and for EBIT it is 16.6% (median 12.4%). All in all, the corporate results continue to be healthy, though there has been some impact on EBIT margins because of high commodity prices.

The market which was extremely strong till October 2021, has been wobbly ever since – what looked like a gentle correction, has intensified in the last few months into a more severe correction. It is perhaps no coincidence that the fall in the market started after the US Federal Reserve (Fed) started tapering its quantitative easing program and moved from an accommodative stance to a more hawkish one and the Fed is now signaling several interest rate increases in 2022. With US inflation running at 7.5% (Europe and UK are not too far behind and in India too inflation has gone a little beyond RBI’s comfort zone), central banks will likely be forced to raise interest rates to control inflation. As we explained in our last newsletter, interest rates are a key determinant in the valuation of stocks – higher the interest rate, the lower is the multiple that one should attach to earnings.

We are quite conscious that impending interest rate increases could have an impact on valuations of stocks and we have been reducing our positions or completely exiting stocks that have risen to the top end of their valuation range. Our effort is to redeploy these funds in other stocks that are trading at reasonable valuations. Our observation is that we are in a two-tiered market – while a section of the market is trading at expensive valuations, there are others (including several stocks in the portfolio) where stock prices are trading at close to or below their March 2020 lows. So there are opportunities for us on both sides – to sell the stocks that have become expensive and to re-deploy in stocks that are still trading at reasonable valuations.

2022 started with a bout of volatility in all global markets. First came the news about omicron, which has been mostly mild in its impact and the high vaccinations over the last year have definitely helped keep hospitalisations and deaths low. As this good news about the pandemic flowed in, the market was strong in the early part of the month until mid-month we had the release of the consumer price inflation (CPI) for the US, which came in at 7.0% – inflation has been trending higher through the year on the back of a rise in food prices globally, rise in industrial commodities like oil and metals and some part of the inflation is also blamed on the supply chain dislocations because of covid. US inflation at its current level is the highest in 40 years and although some of it can be explained by temporary factors, it has become a worry for the US Federal Reserve (Fed) which is tapering its quantitative easing program to end by March 2022 and an intended interest rate increase around the same time. This signals a change in monetary policy as the Fed moves from an accommodative policy to a more hawkish tone.

The Fed is committed to a target of 2% inflation and as inflation in the US trended higher than that over the last 9 months, the Fed explained it away as transitory – however over recent months, the trend in inflation has remained persistent leading to a change in stance from the Fed. What is also perhaps worrying for the Fed is persistent wage inflation in the US. Meanwhile we have seen a spike in inflation in Europe and UK as well – Europe’s December inflation print is at 5.3%, while UK is at 5.4% which are multi decade highs.

The intrinsic value of a business is the sum of all the free cash flows that you can get from the business until eternity discounted back to today at an appropriate discount rate. This discount rate has a large relationship with the prevailing interest rate in the economy and this is why interest rates prevailing in the economy play a large role in the valuation of equities. Higher the interest rates, lower would be the multiple that one would use to value earnings.

The higher inflation figures out of the US, Europe and UK have had an impact on equity markets across the globe – the effect was most visibly noticed on “growth” stocks, stocks which are expected to grow their revenues at a high rate and have been of late, trading at high valuations in the market place. In India too, we have seen over the last few years that companies reporting good growth numbers in an otherwise weak economy, have been bid up considerably and valuations for this sub-set of stocks are high.

We did a study among the BSE500 constituents with the following criteria – 10-year median Return on Equity (ROE) above 15%, revenue growth over 10 years above 8% per annum and current Debt/Equity less than 0.2 – the criteria are some measure of a high-quality company. Totally 58 out of the 428 non-financials made the cut based on longevity, trading history and the application of criteria listed above. The below graph looks at the premium over the 20-year median PE that the current Price to Earnings (PE) based on trailing 12-month earnings is trading at on 28-Jan-22.

Premium to Historical Multiple of Earnings – Non Financials
Premium	Number of Companies	Proportion
>200%	11	19.0%
100 – 200%	11	19.0%
50 – 100%	11	19.0%
0 – 50%	18	31.0%
< 0%	7	12.1%
Total	58	100.0%

As one can see, 19% of the sample is trading at a greater than 200% premium to the historical median; together the top 2 buckets constitute 38% of the total and only 12% of the sample is trading at a discount to its historical median. Admittedly, trailing 12-month earnings may be slightly depressed because of the impact of the second wave of covid, thus overstating PE to some extent. Yet it does paint a picture of how valuations in the Indian market are stretched in many pockets in relation to their historical median.

We ran the same exercise for the banks and NBFCs in the BSE-500 – when we applied the criterion of 10-year median ROE greater than 15%, and gross non-performing assets in each of the last 3 years less than 5%, 15 companies made the cut. For this set we looked at Price to Book Value to gauge valuation of the different companies and calculated the premium that they are currently trading at, to their historical median. The results are below, which indicate that a majority of the better quality banks and NBFCs are trading at a discount to their historical valuations.

Premium to Historical Multiple of Earnings – Financials
Premium	Number of Companies	Proportion
>200%	1	6.7%
100 – 200%	3	20.0%
0 – 100%	3	20.0%
< 0%	8	53.3%
Total	15	100.0%

The above analysis, particularly for the non-financials, indicates that this is a market in which one should tread carefully and we have been trying to do that – we have been reducing positions in some of our “growth” stocks which had gotten ahead of historical valuations significantly and we have been trying to deploy the proceeds in other quality stocks which are trading at a discount to their intrinsic value. We expect to continue with this discipline.