“Incrementally over the past couple of quarters, we have been recommending to clients that NBFCs now is the time to be a bit more selective. The reason is primarily three-fold. One is the starting point of valuations—they are close to their long-term averages, or some are trading rich. Rightfully so, it is accompanied by superior earnings growth. Secondly, on a relative basis, vis-à-vis private banks, the earnings premium that NBFCs deliver is going to narrow. There is nothing wrong with larger NBFCs—they will still deliver a 25% kind of earnings growth CAGR over the next couple of years—but for most banks, including PSUs, earnings growth is set to inflect. The relative earnings premium that NBFCs used to deliver is shrinking. Thirdly, the key risk for NBFCs from here on is margins. Despite 125 basis points of rate cuts, yields for non-AAA rated NBFC paper have not reduced in the last one and a half years. There is clear differentiation even within AAA-rated or corporate-backed NBFCs,” he said.
Shah highlighted that while NBFCs have benefited from lower bank borrowing costs, higher market borrowing costs are offsetting these gains. “Cost of fund reduction on back of the repo rate cuts may not come through, which can lead to earnings cuts for NBFCs,” he noted.
Looking at the NBFC universe, Shah recommends focusing on those that are diversified and have relative advantages on the liability side, such as parentage or strong credit ratings. “They seem better placed and will deliver stabler earnings growth over a longer period of time,” he said.
Digital lending is expected to reshape the NBFC landscape over the next three to five years, with players like Airtel and Jio entering the market alongside established names like Bajaj Finance. Shah believes that while newer entrants have a meaningful right to win in digital distribution and liability advantages, execution will be gradual. “It took Jio Finance three years to reach a ₹20,000 crore loan book on the NBFC side. In the near to medium term, there is no material threat to larger players. Competitive intensity will increase, but larger or more diversified players have levers to offset digital competition. It is a gradual scale-up and nothing to worry about immediately.”
Valuations remain a key consideration. Shah noted that high valuations for NBFCs are partly justified by their natural lending growth, but rationalization may occur as digital lending becomes mainstream. “For larger NBFCs delivering 20-25% earnings growth, even with some compression in valuations, investors can still expect decent 18-20% CAGR returns,” he said.Regarding market patience, Shah observed that valuation resets are sometimes necessary when earnings growth slows. “If one expects steady 20-25% earnings growth and the new reality is 15%, there has to be a valuation reset. In cases of temporary blips, markets may eventually be patient, and it could be an opportunity to double down. Take Chola Finance: same time last year, its stock was materially below current levels, and the bigger picture remained intact,” he explained.As NBFCs navigate a changing financial landscape, selectivity, digital readiness, and a focus on long-term earnings stability appear to be the guiding principles for investors.
