Fundamentals vs process: The case of Edelweiss Financial Services

Why we invest in stocks, not companies.

One of the key principles we consider when we look at investing in public equities is the fact that we are investing in stocks, not companies. With the benefit of hindsight, an excellent example of this is the case of Edelweiss Financial Services in India.

This is a tale of how market narrative and investor psychology can (and often does) trump company fundamentals when it comes to determining value. And it’s a reminder of why as managers, our conviction should be in our process, rather than in our ideas.

To be absolutely clear, we are of the opinion that Edelweiss is one of the most innovative and entrepreneurial financial institutions in India. As founder Rashesh Shah never fails to remind his clients, investors and employees, Edelweiss stands out, having grown significantly without the help of a parent company’s balance sheet.

As investment managers, we have dealt extensively with the team at Edelweiss across all levels of their institutional business, from research to sales to trading to custody. In addition, they have also given us access to senior management in other parts of their business, particularly their life insurance and asset reconstruction businesses. Through it all, our experience has been outstanding – the lack of parent company support has been turned into an asset, helping to diversify business lines and build partnerships with international investors. This has driven investment into both the company itself and also its fund products, from the likes of Le Caisse de Dépots et Placements de Quebec.

Yet, for all of its success, the stock price tells a different story. From a high of Rs 326 in May 2018, the stock has fallen almost 80%, trading at around Rs 72 mid week. Such a move would have been typical for the stock of a company that’s structurally declining, or perhaps one caught up in a scandal of some sort – but certainly not a high quality firm with a growing business, positioned to benefit from structural tailwinds of financial inclusion and adoption.

Collateral damage

As far as earnings trajectory is concerned, one could hardly ask for a better looking growth story.

With its humble beginnings as just one of many of India’s non-banking financial companies (NBFCs), Edelweiss started its life as a capital markets advisory business, gradually growing into the broader brokerage and research space. Whether by genius or by fluke, 2007 saw the establishment of Edelweiss’s Asset Reconstruction Company (Edelweiss ARC), specialising in the rehabilitation of financially distressed but otherwise high quality operating assets. By 2011, new business lines including a tie-up with Tokio Marine to build a long-dated cashflow source from life insurance policies came into place, and in the ensuing years, the company has tirelessly sought to grow and diversify its revenue streams, with housing finance, agricultural finance, asset management and private wealth management business streams gradually being built up. Over the past 10 years, revenues grew almost tenfold, with earnings up fivefold. Every five years, the Edelweiss team sets extremely ambitious targets and every period since inception has resulted in them comfortably surpassing these targets.

Perhaps the greatest gift, and subsequently the greatest bane, to the Indian financial services industry was the decision by the Modi government to undertake its “demonetisation” exercise at the end of 2016. The announcement on the 8th November of the replacement of Rs 500 and Rs 1000 notes was not only unexpected (notification of an unscheduled government announcement at 8.15pm that day was thought to be something to do with military action in India’s northern borders), but profoundly changed the nature of how Indian people view money.

Overnight, illegal cash hoards all over the country were rendered worthless, and the only people allowed to exchange large amounts of old cash for new cash were the poorest in Indian society, especially farmers and labourers. For everyone else, cash proceeds from tax-evasion were written off to zero. Poetic justice aside, this move profoundly changed the way Indian society as a whole viewed the financial markets – whereas people previously had a strong preference for hard assets like gold and real estate, demonetisation shifted preferences squarely towards liquid financial assets. For an entire year, deposits flooded into mutual funds and other financial instruments, a windfall for financial services operators, especially those focused on the upper-middle income brackets like Edelweiss.

Financialisation of a hitherto cash-centric system came as a blessing, but like all blessings, it was not without risk. The influx of liquidity into the system lowered the cost of funding for a time, while the meteoric rise of monthly contribution schemes to pensions and mutual funds helped to sustain the trend. Yet rapid financialisation of a system is accompanied by the construction of linkages between previously disparate segments of the economy, and with interconnectedness comes interdependence – and ultimately elevated risk of contagion.

Cue a textbook lesson in contagion. On the 21st of September 2018, one of India’s largest housing finance companies, Dewan Housing Finance, saw its shares trading down -42%. The reason? A slug of its bonds had been sold by a local mutual fund at a yield of 11%, rather than the 7-8% they typically traded at. Whether the point of distress was on the part of the vendor or on the company was not important – the narrative in the NBFC space immediately changed.

Suddenly, EVERY one of India’s NBFCs was a liquidity risk, regardless of quality. EVERY one of them would be liable for default. As a result, EVERY one of them had to be sold. Including Edelweiss.

Dixi, Ideo

I said it, therefore it is so.

And indeed it is – over the ensuing 12 months, the change of market narrative has been a complete about-turn. Not only did NBFCs (with the exception of the perceived Rolls-Royce of the lot, HDFC – another example of a narrative extreme) go from darlings to being pariahs, so did the privately owned banks, which were previously hailed as the antidote to India’s clumsy and corrupt state-owned banks.

As capital drained from these financial providers, what was a perceived shortage of liquidity turned into a full-blown liquidity squeeze, a self-fulfilling cycle that ultimately creates material impact on the viability of business models. They think, therefore it is so – this is nowhere more true than in an industry built on fiduciary duty and credit: fiducia (trust) and credere (to believe).

In the words of Rashesh Shah in a published interview:

Every industry goes through a re-engineering or a recalibration. In every industry, cycles are inevitable. I would treat this as a cycle in the NBFC evolution and in the cycle, there is a cyclical element and a structural change element. What will change structurally is that NBFCs will no longer be asset-heavy and longer-tenure entities. Very large asset books will not be supported by the liability profile. Also, in the asset book, tenures will come down. That is why models like co-origination make sense, because you are not increasing your balance-sheet size, but you are using your origination and collection skills.

Has Edelweiss had to evolve in response to the changes in industry structure? Definitely. Has it lost its edge in terms of innovation, responsiveness and foresight? Doesn’t seem to be the case.

Has it committed a mistake significant enough to warrant an 80% decline in its equity value? Probably not. But then again, was the bull market pricing of the stock in 2014/2015 not then also an over exuberant extrapolation forward of the good times?

That's the difference between stocks and companies. The company was, and is today, one of the best businesses of its kind in India. The stock performance is the overlay of public market participants’ expectations of what lies ahead (usually biased towards the near term) on top of the basic business fundamentals. This layer is sensitive to narratives and they change fast and often.

Companies vs stocks

The natural question that should have followed above was: “So does that make this a buy now?”. But that’s not the question that needs to be answered, because who truly knows? Ideas are a dime a dozen – we prefer to have conviction not in individual ideas, but in the process itself.

Over the last 30 years, as the investment banking/sales and trading space has evolved from the domain of “punters” in “bucket shops” to an increasingly (and debatably) scientific domain, many have attempted to codify the nature of value into some sort of secret formula. From Discounted cash flows to dividend growth models, to Black-Scholes, to regressions to the nth degree, to Monte Carlo simulations: all of these approaches are highly sensitive to subjective and arbitrary inputs. They purport to be able to tell what the value of an instrument is, but ignore the reality that value is what the market is willing to pay for the stock, not the business. We believe the result is a falsely elevated sense of conviction and precision.

If value is what we’re after, there’s nowhere better to look than the chart itself. Indeed, as far as our process is concerned, the fundamentals could be pristine, but the price charts reveal with complete clarity what the market in aggregate thinks of a stock. So, regardless of how much we like Edelweiss as a company, our ownership is, at best, a minority proportion of their common and publicly listed shares.

Process, process, process

That is why process is important, even more important than identifying the narratives driving price action. Fundamental analysis taking into consideration factors like earnings trajectory and financials is important. But a process that ignores the psychological behaviour of the market, represented by the price and volume data on the charts, is akin to climbing a mountain with eyes fixed firmly on the summit, rather than on the yawning chasm just steps ahead. The general direction is up, but the path isn’t straight, nor even uni-directional.

Our process is built to counter our inherent biases – our confirmation bias with regards to information we agree with, our inertia with regards to changing our minds and admitting that we’re wrong, our false sense of belief in precision over accuracy and our familiarity bias, tending to be overconfident with what we know well. It is the ultimate admission that despite having done all the work, surprise surprise, we may be wrong.

And it is in this process that we have conviction – that we will be able to control our losses, cut our losers and run our winners.

Finally to conclude on Edelweiss. We are not here to advise, simply to provide opinion. And our views on the company and in particular its people are overwhelmingly positive. Of course we salivate at the prospect of picking up a world class emerging financial services company at a 0.8x price-to-book multiple on a 12 month forward basis. But before we even think about how much we can buy, and how much we can make, we must first think about how much we can lose.

That’s the process in action.