Why Gold Loan Stocks have performed so well?

The below chart is an interesting comparison of how the two major gold loan stocks in India – Manappuram Finance and Muthoot Finance have performed in the last 1 year. In the last 1 year, Muthoot Finance returned 44% while Manappuram returned 85% during the same period. During the same period, gold prices have appreciated only 15%.

Ironic? As normally we see the financier of any asset grow along with the asset? So what explains this?

Business Model of Gold Loan Companies

Relatively Secure Business Model – Gold loan is inherently a secure lending business, with adequate collateral in the form of gold jewellery.

Unlike other NBFCs, gold loans companies give more emphasis on the value of security (gold) as compared to cash flow of the borrower. This is due to highly liquid nature of the security offered. Furthermore, sentimental value attached with gold jewellery would result in borrower repaying his money to get back his gold.

 [1] Loan To Value Ratio (LTV) – This is an important aspect of gold loan business. Currently, RBI regulations restrict the maximum loan amount which a company can give at 75% of the value of the gold. If you approach a gold loan company, they will finance you to the extent of 60-70% of the value of the gold you put u[p with them.

[2] Spread Arbitrage – Huge divergence in the interest rates.

Gold mortgaged by the borrowers is pledged by these companies with banks from where they get funding (approx. 80% of the value of the gold). Gold loan companies typically charge 20-24% interest rate from the borrowers and they get the money at 9-12% from the banks.

In addition, these gold loan companies also raise funds through long term deposits at comparatively lower rates and then deploy them into short term gold loans. By doing this, gold loan companies earn huge interest spread. It is this huge interest spread that keeps the gold loan companies going.

[3] Focus on Shortened Loan Tenure – The companies have moved to shorter term gold loans that helped them manage the volatility in gold prices and to significantly reduce default risks and auction losses.

Change in Business Strategy

[4] Impact of Gold Prices – When gold prices fall by 15%-20%, the loan company either call the borrower to put up more gold or make good the margin in cash. In case, customer is unable to meet the shortfall and starts defaulting on the loan, then, the company will be forced to auction off the pledged jewellery at a much lower price in the market. Selling used household jewellery in a falling market will invariably lead to a still lower realisation. 

The unique nature of gold and the huge arbitrage that gold companies enjoy in terms of margins and spreads gives them a huge advantage. It is for this reason that despite tepid gold prices, gold companies remain profitable and gold loan stocks have performed so well!

In short, why these companies will grow in future (if at all) will be because of expansion of their market (i.e. they will grow more, if more and more people start taking loan against their gold) and not because of what happens to gold prices.