The recovery in NBFC stocks from post-demonetisation lows has been sharp. We note, however, that stocks that have delivered earnings have led the rally. We remain OW BAF and BHAFIN— moderate upside but there is higher visibility than at other NBFCs.

We divide NBFC stocks in our coverage into 3 buckets

First Bucket—Bajaj Finance (OW), Bharat Financial Inclusion (OW)—Stocks that are less linked to cyclical recovery and hence more likely to sustain strong growth; higher earnings revisions: At BAF, F3Q17 loan and earnings growth were significantly better than expected. At BHAFIN, removal of the RBI cap on cash withdrawals for current accounts should herald a faster return to normalcy in operations. We have raised earnings and PT for both these stocks, significantly. These stocks are now slightly above pre-demonetisation levels and valuations are not cheap, but we expect strong book value compounding to help deliver moderate stock returns over the next year.

Second Bucket — Housing Finance stocks (Equal-weight) — Earnings delivery has been broadly along expectations, but revenue growth outlook is uncertain given intensifying competition from banks: Another debate on which the jury is out, is on whether real estate—and hence mortgage demand—slows down for a prolonged period. Over next few quarters, however, HFCs are likely to see very high requests for lower repricing or balance transfers from their existing customers, given the sharp MCLR cuts by banks. We expect intense competition from banks given weak system loan growth. The spread of SBI’s home loan rates over MCLR has also expanded to 65 bp, which is a risk.
Other risks are higher bond funding costs, asset quality issues in the LAP book. Full valuation in this context keeps us EW.

Third Bucket—Prefer Shriram City Union Finance (OW) to Shriram Transport Finance (EW), Mahindra Finance (UW)—Most cyclically geared among NBFCs, also most hit by demonetisation; Valuation around/below mean levels could result in trading rallies: All three lenders mainly lend in the less formal segments. Near term concerns are impact of demonetisation coupled with NPA transition on NPL slippages in the next two quarters. We prefer SCUF given : (a) Diversified and much smaller loan book with a much larger target segment; (b) Much higher risk-adjusted profitability; (c) Strong pre-demonetisation trends.