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Wednesday, April 11, 2018

Understanding India's Real Estate Sector - Joint Development Agreement

In our earlier post on India's real estate sector, we discussed the different cycles that the sector has seen over the past two decades and the structural shifts that are currently underway. Today, we discuss the basic tenets of a Joint development agreement - an avenue of property development opened up by Godrej Properties and later on embraced by the entire industry.

 To read further, click here.

Monday, April 2, 2018

Understanding the Real Estate Sector in India - The past & the present

India's property market has been the subject of an enduring slow down for the past three years. Weak sentiment, low affordability and a complete lack of trust in the underlying system have sucked the oxygen out of the system. Let us first have a look at some major headlines on the sector that have featured across different tabloids and website

Now, lets turn the clock back to 1994 -

A booming primary market for equities meant that entrepreneurs across the country were flush with funds for the next big move in expanding business. However, most of the Rs 36,000 crores that was raised as 'growth capital' eventually found its way into real estate as a vehicle for parking these surplus funds until they could be channeled into business. This catapulted into a stream of speculative demand that propelled real estate prices to dizzy heights ( so much so that Nariman point was touted to be the most expensive real estate parcel in the world)

Only when the tide goes out is when you discover who has been swimming naked.

The widely held belief across investor groups in the country was an illusion that realty prices could never correct. After all, land is a finite resource and demand for real estate is infinite. In a blue sky scenario of perpetually rising prices, it would not take second guessing as to where most of the liquidity in an economy would be stationed.

What followed, was a mirror image of perception

Property price corrections across different micro markets. H/T - India Today

In light of what we have just discussed, it is not difficult to understand why scores of foreign investors have had their apprehensions on the Indian property market for the longest of times. Real Estate in India has historically been a Pandora's box due to the absence of a proper regulatory framework governing the sector at large - anecdotes of home buyers being duped of their hard earned savings by land bank hoarders are in abundant supply wherever one looks.

On this backdrop, let us first try and understand some of the basic elements of this byzantine industry. There are two key aspects we will discuss in this regard - the sector's contribution to GDP and the element of cyclicality that plagues the business at large

Real Estate is an umbrella term that encompasses different segments namely residential, commercial, hospitality and retail. It forms nearly 8% of the country's GDP and acts as a catalyst to nearly 250 other ancillary industries. Needless to say, any sustained upswing in an economy needs the realty sector to be in the pink of health. 

This is what Abhishek Lodha, MD of Lodha Developers has to say on the far reaching consequences of a prospering real estate market in an economy - 

Housing and construction have always played critical roles in the economy, with construction now the largest employer in the Indian economy. Progressive and developed nations like the U.S.A. , China, and U.K. are some examples, which demonstrate that no economy has grown sustainably without housing growth. We saw how Indian employment and investment grew significantly on the back of the ‘positive wealth’ effect created by housing growth in 2004-2010.
Let's not even for a second, forget the fact that cyclicality is an embedded feature of this sector, not just domestically but on a global level as well. The fortunes of real estate are closely linked to the overall macroeconomic scenario across borders - which in turn is a culmination of several other moving parts - interest rates, fiscal policies, so and so forth. 

Unlike equities and certain commodities, Real estate cycles are far more prolonged - both on the upside and downside. A typical cycle lasts for as long as eighteen years across developed economies -(from peak to trough and back to peak)

Real estate Cycles in the United States( courtesy - Fred Foldvary)

Some important points to note from the above graphic would be
  • Construction activity and land prices peak out almost at the same time
  • Peak to trough movements take anywhere between two to three years to culminate
Cycles in India though, have been much more compressed and volatile as the sector opened up to foreign capital only since 1991 thereby increasing alignment with the global market at large

The fond memories of the boom of the nineties gave way to the misery endured during the turn of the twenty first century. From trough to peak and back to trough, property prices In India traversed a decade of volatility beginning 1992, before eventually bottoming out somewhere between 2002 and 2003
A sample of all real estate companies in India as complied by Ace Equity adds impetus to our observation - Return on Capital Employed slid from a dizzying twenty seven percent in FY'95 to a lowly six percent by FY'04! In tandem, net per-tax margins slipped a whooping 90% from their highs in 1996!

RoCE and Pre tax margin for all companies in the realty sector
(Source - Ace Equity)

A rising tide lifts all boats.

Relaxation of FDI Norms in 2005 promulgated the sector to a wide global audience of investors for whom this market provided a direct avenue to participate in the growth story of the economy at large. Incumbents as well as newly established ventures lapped up the influx of foreign money as a bountiful source of capital to spur activity in the sector. The Indian market though, was just another beneficiary of the global rally in property prices which eventually culminated with the onset of the subprime crisis in the United States. 

Compiling specific data points on the listed companies in the sector threw up certain interesting pointers
  • Return on Capital employed, which had bottomed out near to ten percent (implying negative value creation as cost of capital was anywhere near fifteen percent) trebled to thirty percent by the peak of 2007
  • Inventory days ( which measures the sales velocity for real estate) fell from a peak of 377 days in 2002 to 289 days at the peak of 2008 
  • Even though there were healthy book profits reported during peak, cash flow generation from operations remained tepid, thereby stretching balance sheets across the sector
  • Add to that the rapid expansion drive companies had embarked on, Cash flow from investing further add to the leverage companies had to take on - debt equity ratios for a basket of all listed real estate stocks increased from 1.02x as of FY'03 to 1.7x as of FY'07
It is an anomaly when companies who are growing profits at triple digit rates are compelled to tap external sources of funding to fuel growth. Taking a sample of listed real estate companies for the period between 2003 and 2007, what we found was that despite supernormal growth in profitability, cumulative debt equity ratio increased from 1.02x in FY'03 to 1.31x in FY'07 - an absolute increase of more than fifty thousand crores!

Cumulative Cash from operations for the selected period was a mirror image of cumulative EBITDA!

“Bull markets go to people’s heads. If you’re a duck on a pond, and it’s rising due to a downpour, you start going up in the world. But you think it’s you, not the pond.”

Leverage and incessant speculation are two founding pillars of a bubble in any asset class. What we have understood from the above data is that companies resorted to debt as a substitute of cash flows -to hoard vast tracts of land as end demand from speculators blossomed. In the entire process, both the producer and the consumer chose to turn a blind eye to the cycle turning against their tide 

The magnifying effect that leverage has on a business is most evident when one delves deeper into the devil that lies in the details. For the entire clutch of listed companies, Return on Equity shot up to 45 percent in 2007 from a mere 3 percent in 2003. What's intriguing though is that asset turnover ratio only moved from 0.43x as of 2003 to 0.47x as of 2007. The end result? Value creation across the sector was a direct function of how much leverage each company burdened itself with

In his report titled 'The End Game of Speculation in Real Estate has begun' , Manish Bhandari aptly describes the feedback loop that fuelled the bull market

The "amplification mechanisms", whereby, a large increase in asset price is followed by a higher demand, as investors think that further increases in prices will follow. This "super-exponential" acceleration in prices due to a positive feedback (or "pro-cyclicality") leads to formation and then maturation of a bubble, which has happened in case of the Real Estate prices in India. 

An opportunity size catering to 125 crore Indians, growing in double digits is a lucrative proposition for a swarm of new companies wanting to have a bite of the cherry. And if you add a painful slowdown in off-take, what you get is the prefect recipe for a financial disaster in the making. 

In this entire slowdown, companies who have not been able to deliver on promises ( lack of execution capability) have met with a gnarly end as  plummeting inventory off-take and an inability to service leverage has broken the two major sources of funding that real estate development thrives on. A virtuous cycle of value creation built on the pillars of debt and speculation has metamorphosed itself into a inescapable debt trap for stretched balance sheets

Lack of accountability and capability have been at the forefront of dissent
for the industry at large

A complete absence of checks and balances at various stages of real estate development have for long been hunting grounds for several fly by night developers who have relied on the money of home buyers to accentuate other ventures.This eventually translated itself into a fragmented sector wherein no single player would have a definite command over his/her area of competence.

Let us have a look at what Arihant Superstructures' management had to say on the real estate market of a small town in Jodhpur

The trilogy

In an interview to BloombergQuint, Mohnish Pabrai succinctly talked about a trilogy of events that have shaken the Indian property market over the last eighteen months - Demonitization, followed by the double whammy of RERA and GST.

Let us understand the three events in greater detail.

According to Liases Foras, a real estate consultancy, about thirty percent of all property transactions have traditionally been transacted in hard illicit cash - most of which emanates due to the stark difference between circle rates and market rates. By under-reporting transaction prices, the buyer benefits as he has to pay lower municipal taxes on his purchase and the seller benefits by way of a lower outflow of capital gains tax on the sale of his land.
A blanket ban on 500 and 1000 denominated currency notes bought the entire sector to a grinding standstill. The impact of this move was profound as transactions in markets such as the Mumbai Metropolitan Region( MMR) and the Delhi-NCR region (where a sizeable chunk of overall demand originates from speculators who want to make a quick buck by betting on price increases during the construction phase of a project) took a significant hit .

The first of the trilogy of moves well and truly separated the wheat from the chaff. Developers who relied on this channel of funding for augmenting their business were almost wiped out of the game overnight as the component of liquid cash was no-longer a bankable source of capital to tap into. Real estate development was slowly graduating from being one of uncouth practices and opaqueness to a consumer centric and transparent business model. 

After being in the works for several years and governments, the real estate regulatory act(RERA) was finally adopted in the summer of 2017. The provisions contained within the bill were remnants of a cleanup drive that would completely reboot the sector at large. 

Under the RERA Regime - 
  • companies have to first secure all clearances (which in many case can run upto more than fifty different applications) before launching a project to buyers.  (increased source of alternate funding)
  • Besides this, seventy percent of the booking amount received from customers will have to be maintained in a separate escrow account and shall be used for the sole purpose of meeting expenses pertaining to the construction of that particular project only.( increased accountability and working capital needs)
  • The home builder would be liable towards all defects arising out the construction of the project for a period of five years post completion. (better quality of construction and a need to have a skin in the game)

 In one his interviews, Khushru Jijna, Piramal Finance's MD crisply puts across the fallout effect that RERA would have on the dynamics of the sector at large - 

Indeed, the onset of RERA after the bombshell of demonetization has pegged the entire sector back to square one. As weak hands run for cover, fresh supply into the market has taken a beating and speculative demand as a whole has found alternate sources to deploy capital. 

The end game?

Image Courtesy - Livemint

  • New launches across different cities fell 41% YoY 
  • Sales continue to plummet, touching a seven year low as speculative demand gets wiped out of the market
  • The pace of incremental supply has fallen short of demand, thereby liquidating unsold inventory

Having dealt with the aspect of trust with the onset of the RERA, let us now understand whether prices are really conducive for home buyers as of date.

Pankaj Kapoor, head of Liases Foras, explains the issue of affordability in an interview to Economic Times -

  • Consumer affordability is a function of two distinct factors - price affordability and availability of financing
  • Cost of capital for buying a house (which is the loan rate charged by a bank) is near historical lows which further bodes well for a pick up in sales velocity

Mortgage rate trends in India

  • Low mortgage rates, combined with a time correction in prices points towards a multiplier effect in terms of affordability for the home buyer thereby pointing to meaningfully higher sales velocity. 

To conclude..

The lolapalooza effect that DeMon, RERA and GST have exerted on the Indian property market has chalked out a new path of evolution for the business of real estate development. From a 'pre-sale' model, companies would slowly move towards a 'build and sell' model wherein a significant portion of accruals happen at the later stages of construction. (Note that build and sell here refer to completing construction till a certain milestone before opening it up for sales.)

This shortfall in cash flows would entail latent demand for working capital by way of construction finance - thereby creating a natural barrier to entry. The flip-side of lower sales visibility at the commencement of a project would however propel an element of uncertainty as completed projects may or may not witness traction in off-take as demand is a cyclical element of economics.

Talking in terms of profitability, exorbitant property price rises fueled by speculative demand are a thing of the past - which would mean that a big part of the abnormal margins that accrued for real estate companies during the cycle of 2008 will take a backseat. The forthcoming up-turn in the industry shall typically be led by higher turnover ratios (a big reason for this is the demand emerging from affordable housing) , stable profitability and relatively lower levels of leverage.

In a cyclical sector everyone focuses on the demand side but not many focus on the supply side. When looking at the real estate sector with all the transitions happening the supply seems to be affected in two manners viz:
  • Fall in new construction
  • Consolidation among the builders bringing in new supply 
In lieu of these changes the structure of the industry should look much different than what it has been over the last decade. In the next post we will have a look at individual companies and see how they are adapting to change in the sector

Thursday, January 4, 2018

Indian Banking Sector - the last decade

Banking is a treacherous yet lucrative business and there are institutions and people across global economies who have borne testimony to both sides of the coin. There are inherent similarities between what a bank does and what a trader does - both make money from money, earning the middleman's commission in the process.

Over the years banking has evolved from being a pure play provider of credit to a business offering multiple services under one umbrella. This widening of the ambit of services under offer has led to an increase in the role the management plays in the banking business. Thus we see a stark difference in valuations because of various ways in which banking is done. The difference in operations have led to distinctions like Public & Private Banks, Monolith and Multi operation banks and many others. Through this post we make an attempt to see how the banking sector has evolved in India

The Indian banking fraternity has traditionally been the fortress of State owned enterprises who have held the lion's share of the market. Prior to 1991, PSU Banks accounted for 91% of the total assets in the system as they faced little by way of external competition. As the government and the RBI have opened up the sector over the years, incumbents have lost out on the incremental opportunity on a consistent basis thereby ceding ground to the more nimble and efficient private players.

In the ensuing chart, we have taken the Nifty PSU Bank and the Private Index as the sample sets and highlighted the cumulative advances growth over a ten year period

  • Private Banks have comfortably outstripped their counterparts in terms of loan growth over a ten year period
  • The difference however, is much more visible since the last five years as the bigwigs have barely climbed the ladder of growth


    Problems for SOB's gathered critical mass as the RBI initiated the Asset Quality Review(AQR)  in FY'16 - thereby unearthing a casket of skeletons that Banks had been ever-greening for years. Slippages( which is defined as the amount of loans that turn bad during a given period) increased manifold as non-performing accounts that were being masqueraded as standard were re-classified, leading to a bucket full of slippages being thrown out into the open, especially for Public Banks

    Cumulative annual gross slippages for PSU banks. Note the spike in slippages for 2016

    These slippages have had a direct rub-off effect on the P&L's as incremental slippages leads to incremental provisioning that banks have to carry out against them. This in turn has depleted profitability for state owned banks.

    Growth Banking needs growth capital and one of the primary sources of growth capital for a bank is the re-investment of its profits into business so as to augment balance sheet leverage.
    We collected provisioning figures for the past five years for the Nifty PSU Bank Index to further explore the decay in the Profit and Loss Statement
    (State owned banks have taken a cumulative hit of ~4.5 lakh crores by way of provision in the last five years which has in turn deprived them of an equivalent amount by way of equity capital.) 
    In the absence of book profits, PSU Banks have had to constantly tap external sources of capital to keep the balance sheet afloat

    The cumulative capital raised by the constituents of the Nifty PSU Bank Index has been to the tune of approximately 42300 crores. This has primarily served as a buffer against the incremental provisioning that has plagued profits, leaving little room to grow the business.

    (We assume that a big chunk of this capital for these banks have come in by way of the Indradhanush program of the central government)

    The recapitalization
    The government's decision to infuse a mammoth two lakh crores into its banks to recapitalize balance sheets has been well received by the corporate and the investment fraternity alike. 
    For starters, let us first explore the cumulative networth of the Nifty PSU bank Index


    Addition of approximately two lakh crores would mean that the total equity would now go upto nearly six and a half lakh crores. With enhanced Tier 1 ratios, bank managements would have the luxury of throwing in the kitchen sink of provisions and expanding balance sheet leverage to revive capital formation in the economy.

    Let us first explain the part on provisioning.. 
    Net NPA's of PSU Banks

    Net NPA's are simply the residual bad loans left after the provisioning done in the profit and loss statement. The RBI puts forward two broad categories/steps for providing for bad loans - substandard and doubtful. Within doubtful assets, there are three sub-categories based on time periods - upto one year, one to three years and more than three years. The quantum of provisioning at each stage is well explained by SBIN in their annual report

    Out of the cumulative NPA's of 2.3 lakh crore, one would assume that cases referred to the NCLT would form a major portion of the pie. (For instance, stressed Steel accounts contribute to thirty one percent of total NPA's for SBIN!)

    Resolution of these large cases would then dictate the quantum of write-offs that banks would have to further take on them. Subsequent to the provisioning, banks would then have the remainder of the recap money available for re-investment in the form of growth capital.

    As a summary, an investor can look at two key factors for PSU Banks in the coming months

    • The resolution of cases referred to the NCLT  - the quantum of recoveries would dictate whether banks make or write back provisions
    • Post resolution, the amount of growth capital that each bank would have at its disposal

    Wealth Creation in banking has been a direct function of two key features - a vibrant corporate culture and strong credit under-writing. It is the combination of these two factors that has led to creation of brands like HDFC in a business which sells plain vanilla commodity products. Public sector banks have for long been at the receiving end of following substandard appraisal processes, leading to significant erosion of equity over the years. The bank recap plan should go a long way in healing near term stress - but, will the nightmare of the past decade make these organizations leaner for the future? Only time will tell.

    We will continue this post with a primer on understanding basics of the banking sector and what one needs to understand while looking at the financials of a banking company

Thursday, December 14, 2017

Understanding Sugar Sector Part 2: "When Growth Kills"

In our previous post on the Indian sugar sector, we discussed how incumbents have found it extremely difficult to operate in a myriad of regulations that govern the operating cycle of the industry.

In this post we have tried to present a picture of how the companies in the sector stack up against each other by comparing them across some parameters that we find useful in comparing companies in the sugar sector and have highlighted our findings below:

Commodity businesses derive their moats from being cost leaders and generally industry leaders tend to be the most efficient companies in the business as economies of scale works to their advantage. The cost intensity of manufacturing sugar means that companies must optimize cane procurement and conversion processes so as to increase the recovery rate.

However, as we can see in the sugar sector the leader seems to be reeling under extreme stress. We already know that a leveraged balance sheet in a cyclical sector lends itself to a plethora of pain when the force of gravity imposes itself on the business. The manufacturing of sugar is both fixed and working capital intensive and only a select few are able to withstand the wild cyclical swings. Shishir Bajaj led Bajaj Hindustan is the industry leader with a crushing capacity of 136,000TCD and has been the torch bearer of the stress faced by companies across cycles
We have compared Bajaj Hindustan to Balrampur Chini and Dwarikesh Sugar on select parameters to understand why the sector leader has performed in this fashion and how other companies have taken advantage of this and have highlighted our findings below -

  • We first compared the gross margins of these companies to understand profitability that accrues to the sector. Incremental gross margins for an integrated sugar company are primarily driven by the sale of associated by-products as the marginal revenue accruing from these is significantly higher than the marginal cost incurred in the conversion process

The observations from the above data are quite intriguing especially in light of the fact that Bajaj Hindustan actually has the lowest contribution from sugar to its overall revenues

Sugar contribution to overall revenues for the three companies

  • The most common yardstick of a mill's efficiency is the recovery rate of sugar. Within Uttar Pradesh, mills located in the eastern region of Bijnor have the highest recovery rates, due to usage of high-yielding early sugarcane varieties like CO 0238. These early varieties of sugarcane fetch the farmer Rs 10 more per quintal than the general variants.
    Bajaj Hindustan's mills are predominantly situated in and around the district of Lakhimpur Kheri which is towards the southern part of the state. We took the recovery rates for both DCM Shriram (a listed peer with a presence in the same region) and Bajaj to check how recovery rates differ for both companies

The difference in recovery rates is quite stark and as both companies have mills around similar geographies. To understand why Bajaj Hindustan has sub-optimal gross margins and recovery rates, we compare and analyze the cash conversion cycle for BHSL vis a vis its peers

The payable days for Bajaj Hindustan are nearly four times its peers - thereby leading to higher COGS as the company is obliged to compensate in the form of interest payments on its dues to farmers. Sugar companies have to keep a high inventory component as crushing is a seasonal activity but demand for sugar is secular, and while the other companies finance this through working capital loans, BHSL does it through delaying cane payments as the balance sheet does not have scope for further leverage

Keeping the cane farmer happy is central to the sustainability of this business - and any delay in payments has a prolonged impact on the goodwill of a sugar mill. Add to that, the penal consequences imposed on delayed disbursements are severe as the state government has imposed strict norms to ensure timely payments.

Source: Financial Express, 13th April 2017                                    

The natural chain of events would suggest to us that Bajaj Hindustan would invariably face the wrath of the farming community in the form of both low quality as well as quantity of supplies. We took the crushing capacity / day for Dhampur Sugar and Dwarikesh Sugar (both of whom have a presence in the area of Bijnor) in our effort to understand the root causes of in-efficiency for BHSL

(Bajaj Hindustan and Dwarikesh both changed their accounting months in 2014 and 2015 respectively)

Despite having the largest capacity, Bajaj Hindustan operates its mills for the least number of days in comparison to peers. The underlying scale of business hence loses out to operational in-efficiency, thereby creating a lollapalooza of ever surmounting debt and farmer agitation thus leaving the company in a situation of mess which is difficult to come out from.

We will continue this post with further work on companies highlighting how they have positioned themselves differently so that  once this honeymoon period for sugar sector gets over how can they emerge better positioned to weather the downturn in cycle that awaits them in future.

Monday, December 4, 2017

Capital Allocation - A tale of two companies: Reliance AMC & Motilal Oswal Financial Services

Investors have always been attracted to companies which are cash generating machines. The reason is simple. The cash generators survive market cycles. They keep doling out huge cash in turn which is either re invested if the business is in growth phase or returned as dividends if the company is in mature phase and doesn’t needs cash for reinvestment. In both the cases its beneficial for the minority shareholders because internal accruals is the cheapest source of capital for a company to build a business while if free cash is given off as dividends or buybacks it puts money in hand of shareholders directly.
While the free cash generation capacity makes these business attractive there is an inherent risk which lurks which some investors fail to identify. Capital Allocation becomes very important for a company which is generating huge amounts of cash from its operations. The simple thing to do would be to keep re investing in the business but not all businesses are at similar stages of growth. Thus some companies choose to give off the money as dividends to shareholders. However, in a case where a company does not share cash with shareholders but re invests in its business it needs to be identified whether the business is/will be able to generate returns higher than opportunity cost of capital for shareholders. Many times companies have squandered cash from good business in bad business while showing it off as diversification. However it becomes difficult for an investor to differentiate between diversification and wasteful conglomerisation. The loser is the minority shareholder.
We can see the difference that capital allocation makes on returns for a shareholder
  • ITC has grown market cap at a rate of 22 percent over a growth in reserves of 19% while VST Industries has grown market cap. at a rate of 26 percent with a much lower growth in reserves at 11 percent
  • While ITC ploughs money from highly profitable ciggarate business into loss making hotels, early stage FMCG, agri operations etc VST follows a simple approach of paying off cash as dividends
  • The difference in returns for a shareholder in VST and ITC are there to see
To put in simple words an investment of Rs 1 lakh made in ITC 14 years ago would have resulted in Rs 16.55 lakhs while a similar amount invested in VST Industries would have resulted in Rs 25.5 lakhs. That is a difference of over 50 percent on the final amount. This is why capital allocation is important for companies and also for investors

Over the last few months a new space that has seen much action in the recent times, one due to inflow of money by domestic investors which has made the “assets under management” (AUM) touch new highs everyday while next due to the listing of one of the biggest companies in the asset management space – Reliance Nippon Asset Management Co. (RNAM) is the “Asset Management” industry.
The point that catches our eye in this industry is the ability to generate large amounts of cash flow and minimal use of capital to grow this business. This is a combination which will allow companies in this space (especially leaders) to generate large amounts of cash. We find this business to be very interesting because capital allocation will become very important when you have large amounts of idle cash. It is a great way to test management honesty and acumen.
We have already seen how capital allocation of management decides what will future returns are from a cash generator. Thus now let us have a look at how two companies in the AMC sector operate and let’s understand how they are allocating capital for themselves and their shareholders  
Motilal Oswal is a diversified financial conglomerate with varied interests in the areas of broking, asset management and housing finance. On the other hand, Reliance Nippon is a pure play Asset Management Company with a host of offerings that include mutual funds(both debt and equity) , Alternative Investment funds and Portfolio Management services for both individuals and institutions
First we would like to give some facts about the AMC industry in India
  • There are 41 AMC’s in the country, of which 9 are owned by government, 7 by foreign and 25 domestic private institutions
  •  Five of the top AMC’s control 57 percentage of the market with 36 accounting for the rest
Now we start our exercise in understanding the fund structure and capital allocation policies which both Reliance AMC & Motilal Oswal following terms of deploying the windfall that they get in terms of free cash.

Reliance AMC
To understand the implication of capital allocation policies, let us first look at the difference between core business pre-tax RoE's. The pre tax RoE in this case is equal to the PBT + unrealized income on investments divided by average equity
The profit before tax includes the component of other income which should be subtracted to understand core business RoE's. Similarly, the denominator should be reduced by the amount of interest/income earning assets that the company has invested into. The excel attached below shows the calculation for the same
Thus core ROE’s of AMC business which Reliance operates is on an average over 100% every year which portrays the operational strength of the industry in which it operates. The benefit of operating leverage once leadership position is established is enormous for the industry
Now to answer the question that why reported RoE's are so depressed in relation to core business RoE's?
We listed down all the investments that the company had made from its internal accruals and calculated the subsequent returns earned. To not obscure our findings, we included both realized and unrealized gains that have accrued to the company
  1. The company practices a diversified approach to asset allocation
  2. The part that is worrying are the inter corporate deposits, more so because we know who the related party for Reliance AMC are
  3. Even though the fund house has a sizeable private equity corpus, the balance sheet doesn't seem to have any investments into them as of March 2017
  4. The returns for a shareholder of RAMC would depend upon asset allocation policies of the management

Motilal Oswal Financial Services (MOFS)
It would be imperative for the reader to understand that MOFS is a diversified financial services business with interests in the credit business as well. So in this regard, an apple to apple comparison is not possible. What needs to be done is that the consolidated balance sheet of the company must be looked at ex of the loans and advances made as they pertain to the housing finance business if one needs to compare yields that both companies are earning on their investments
We took the data of the last three years for Motilal AMC (as the mutual fund schemes were launched only in the year 2014) and tried understanding profitability trend through ROE since inception of the schemes (prior to the Mutual fund triumvirate, MO-AMC was a pure play portfolio management services firm with an AuM growth of 10.65 percent in 7 years)
Let us now look at the capital allocation policies of MOFS
  1. The company practices an approach which is highly tilted towards equities and real estate
  2. Amongst equities MOFS also runs a private equity business which allows an investor to take exposure in the highly lucrative private equity and venture capital space
  3. MOFS also runs a Real Estate fund which gives exposure to real estate opportunities arising in the country
Reliance AMC vs MOFS
  1. While MOFS is a firm specialized in one domain – equities Reliance MAC manages a diversified pool which includes debt assets as well where the yields are very low thus depressing yields
  2. While the clients of MOFS includes HNI’s interested in PMS and equity schemes Reliance AMC manages the corpus for EPFO & NPS pension scheme which carries virtually zero yields
Thus the capital allocation of MOFS is tilted towards only one domain ie. Equity while Reliance has diversified it across multiple asset classes and also there seems to be some unanswered inter corporate loans which warrants further attention.