Ask any financial planner or investors and they will tell you the magic of compounding and how good it sounds if you keep compounding your returns for the long term.

 

If someone asks me to give an example of compounding, I will definitely point them at HDFC Bank. At Value Operations, especially to our managed fund business, our vision is to invest with India’s top 20 companies where we see a potential of growth in its values and accumulate them when ever they are trading at discount to its value.

 

We call this vision as “20/20 vision”. So our goal is to create a portfolio of 20 great companies by ‘2020! We are definitely not in any kind of rush.

 

Banking business is all about leverage. If you understand this business then to find jewels within this sector is not tough. In simple terms if I have to explain about this business then bank takes deposits from its clients and in return pays interest against their deposits. After collecting all the deposits they lend that money to someone who needs those (loans) at certain interest rates.

 

The difference between those two interest rates is what banks make their profits. When you are evaluating any bank, it is important to understand the mix of their loan book (whole sale, retail, auto, home loans etc.) and their quality and risk ratio.

 

The last thing to look at it is their expenses against their gross income. We call this ratio as ‘cost to income ratio’. In the developed countries like US, UK, Germany, Canada and Australia, all the banks are targeting their ‘cost to income ratio’ to come down below 40%. In my opinion, in the country like India, our banks should target this in range of 35% -40%.

Looking at HDFC banks yearly reports then their Deposits have grown by 18% and their loan books have grown by 22% in the year end March 2012. In their first quarter results for 2013, they have managed to grow their deposits by 4% and their loan books by 9%.

 

In such a high interest rate environment, to manage to grow their loan books by 9% is a great achievement by HDFC bank. But is this a sign that they are compromising on their quality to gain business?

 

The ‘cost to income ratio’ for the year end 2012 stands at 38% which is far better compare to 2011 ratio of 45%. HDFC Bank is growing its profits by more than 30% every year. But at the same time they are retaining almost 80% of their earnings back into the business to grow their profits. The average contributed equity by their shareholders has also grown by 28%. As far as earnings are growing at faster rates then contributed equity it is considered as efficient business.

 

But isn’t investing is all about getting enormous returns? To gain big returns you need to buy them when they are trading at cheap or discounted rate. HDFC Bank has been very popular with investors and has always been found trading at premium to its intrinsic value of underlying business.

 

HDFC Banks ROE as per Value Operations is 19%. If I assume that they will grow their earnings again by 30% then we value this business intrinsic value to be Rs 290 for 2013 and Rs 380 for year end 2014.

 

What do you think? Is it cheap to accumulate or wait for the right time to get into this business?