Intermede talks tailwinds supporting valuation in financial stocks

Funds Management

by Clive Tompkins

Intermede Investment Partners Financial Analyst, Richard Thompson and NAB Asset Management Portfolio Specialist, Sinead Rafferty discuss the tailwinds supporting valuation in Indian financial conglomerate Housing Development Finance Corporation Limited and US retail financial giant Charles Schwab Corporation.

Sinead Rafferty: Welcome to the Intermede Investment Partners update. My name is Sinead Rafferty Portfolio Specialist at NAB Management. And I'm joined by Richard Thompson Financials Analyst at Intermede. Welcome Richard.

Richard Thompson: Hi.

Sinead Rafferty: So, one of the recent additions into the Intermede fund is HDFC. Can you tell us a little bit about the thesis behind that addition?

Richard Thompson: Yeah sure. So HDFC is an Indian housing finance company. This is a market with huge structural growth prospects, and that's driven by, in part, there's low current penetration of mortgages, so mortgage debt, in India, represents about 10 per cent of GDP. That compares to more than 20 per cent in China, for example, and 60 to 80 per cent in most developed markets.

And that's supported by favorable demographic trends, so, India has a very young population. Two thirds of the population are less than 35. Indians tend to buy houses quite late, so the average age of a home buyer is 38. So that gives you two thirds of a population moving through that age bracket in the foreseeable future.

So then also, you have favorable economic trends in terms of the rising middle class, in terms of urbanisation, and in terms of nuclearization of family households. So right now, the structural trends are being supported by government measures. It's one of the government's top priorities, is trying to tackle the housing shortage in India.

That's estimated at 80 to 90 million houses that need to be built in India, so the government is targeting 50 million houses to be built over the next five years. So if HDFC maintains its share of that, that's a huge acceleration in growth. If these 50 million houses are delivered, 20 million would be in HDFC's target bracket, that could be a doubling in their growth rate.

The government is also, they're trying to incentivize everyone within the housing finance chain. So they're to incentivize developers via tax breaks and providing land for them to build on, and they're also trying to incentivize purchasers through tax breaks, and they're trying to incentivize the lenders through regulatory changes.

So, all these structural trends, I mean, this is a very long structural growth story for Indian housing. And HDFC is the best way to play that. That's because HDFC, they have significant competitive advantages. So on the asset side, it's an undifferentiated product mortgages so the way to compete effectively, is on the cost side. So HDFC it is the largest housing finance company, it has the most efficient cost base, and they also have the lowest funding costs. So, HDFC can offer a loan on the same terms as a competitor whilst making a significantly higher return on capital.

So what we look for at Intermede. We're looking for high growth and returns on capital, and to compound that growth over time. So, HDFC, the market is a huge growth opportunity. They generate very high returns on capital. So it's 20 per cent loan growth, 20 per cent return on capital, and that compounds over time and you get this type of compounding in the value of your investment.

Sinead Rafferty: Sounds like an incredible growth opportunity. Can you tell us about your view on the market in general. There's been a lot of talk in the media. The valuations are stretched, the markets are looking expensive. What's the Intermede view?

Richard Thompson: Sure. I think there are pockets of the market where we see over valuation. I think the market, in total, in various metrics it looks expensive, some metrics more so than other metrics. I think we focus a lot on free cash flow, so free cash flow yield of the market at 4 per cent. It's not a huge amount away from where it has been historically, that’s averaged 5 per cent.

It looks a little bit expensive in totality. There are pockets where we think there is over valuation, but we're very happy with the companies that we own. Valuation relative to the growth opportunity and the returns on capital. We have a very concentrated portfolio, or fairly concentrated. We own about 40 names, so we can easily avoid the pockets of over valuation and invest in the areas where we see valuation upside.

Sinead Rafferty: Can you tell us about another stock in the portfolio that you're excited about at the moment?

Richard Thompson: Sure. We have a fairly concentrated portfolio, as I mentioned, so we only have six stocks in financials, so, I'm excited about all of those stocks obviously. It's a very short list, so, out of all the 400 plus stocks, I've chosen the six that I like the best. So I like them all.

I guess Schwab one which is interesting at the moment. So, Charles Schwab is a retail investment services provider in the United States. So this, again, is a large market. It's $35 trillion investible assets in the U.S. and it's growing very strongly, it grows 8 to 10 per cent through the cycle.

So Charles Schwab, they are huge. They have $3.3 trillion in total client assets. But that's only 10% of the market. And they grow, they take share consistently over time. Now you've got a huge area of space, in terms of market share, to take over a long period of time, and that market's growing as well. So it's a huge growth opportunity for Schwab.

So why is it that Schwab can take share consistently over time? The reason is the business model. Schwab has a very intelligent business model, which is where they mix technology and human capital, so they can deliver a high quality service at a very low cost. So Schwab has, what we call first mover advantage, and that is because they're so far ahead of the competition, with $3.3 trillion of assets, that it's almost impossible for the competition to catch them. And that's because they have the highest operating cost efficiency, so they're able to charge the least and still make a very strong profit margin.

So, Schwab charges clients, on average, 28 basis points on client assets. The closest competitor, their cost base is 28 basis points of client assets, and that ranges for the competitors 28 to 90. So no one can compete with Schwab. They can't charge 28 basis points because they can't make a profit at that level. Actually, most of them are making a loss at that level.

So, for that reason, Schwab is able to charge the least, but their cost base is so low. They have a 40 per cent profit margin, the peers are making 10 per cent profit margins and charging far more. So, you set that up, you've got a huge, growing target market. Schwab is the preferred provider because they provide the highest quality service at the lowest cost. So they continue to take share every year.

And then, that's supplemented at the moment by cyclical tailwinds as well. So, Schwab's revenue is very sensitive to interest rates. So US interest rates are rising at the moment, and that's a huge tailwind for Schwab's earnings.

There was some concern about China. There was some concern when the oil price fell. Inflation fell. People started to think interest rates are going to remain low forever. So, for us, that was an opportunity. Schwab's valuation came right down, it was a company we've liked for a long time, so we follow it. We waited, and at that point in time, the shares were very, very cheap. So we entered a position at that point.

Since then, inflation and interest rate expectations have improved and the stock's more than doubled since we bought it in 2016, but we still see a huge valuation upside. A huge growth opportunity for them over the very long term so we continue to be holders.

Sinead Rafferty: Sounds like a really good story, and unfortunately, we can't hear about the other four in your financial sector, but thank you so much for your time Richard. And thank you for joining us. If you'd like to find out more about Intermede, you can find it on the website where you launched this video.


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