As fascinating as Banking and Financial sector is, it is cyclical in nature. They lay the seeds of success in bad times and cut off the roots in the good times. Banking is a very good business if the bank can avoid making irrational decisions. Follow Amitabh Bachchan’s axiom “Parampara, Pratishtha, Anushasan” and banks should run fairly well.
Current Picture
The earnings momentum of banks is extremely positive right now with low NPAs, clean balance sheets and expanding NIMs. It paints a positive picture for the sector in the next 1-2 years, however, NIMs could peak out and the impact of high inflation and interest rates should become more prominent on the bank balance sheets gradually. Rather than the entire sector doing well, I feel we are at a stage where we need to focus on nuances of individual bank practices. Good Banking business is not built by good laws but by good bankers and sound management teams. Would be selective in terms of which bank or NBFC stock to invest in the current scenario.
Stick with proven names that have gone through multiple cycles unscathed
Factors like growth in deposits and advances, consistency in NPA management, cost to income ratios and capital adequacy are relatively straight forward to evaluate. Aside from these metrics, I would like to focus on the ALM management in a little more detail.
ALM (Asset Liability Mismatch) is not an anomaly when it comes to banks. It is embedded in the design and revenue models of financial institutions. Having a shorter duration liability profile and longer asset duration profile, is a means to earn extra margin. These ALM conditions will continue to exist as long as banks exist. For it to work well, there are two engines – (a) Trust of the depositors and (b) ALM practices by the management team. If one of the engines goes off, the bank is on its way to self-destruct.
Take for instance, if the trust factor goes away, the bank can end up in a situation where the depositors withdraw the money at the same time. In such a situation, the bank may not have the funds to do so, as they are all locked up in long-term loans.
This is the scenario which has played out for many NBFCs in India over the years. IL&FS was a classic example of this asset-liability mismatch.
To test the bank’s position, I look at the detailed Basel III disclosures by each bank. Generally, an increase in interest rates has a positive effect on Net Interest Income but a negative impact on net worth. The magnitude of this impact depends on how effective the bank’s ALM practices and asset-liability duration gaps are. For the data enthusiasts like me, I have tabulated this impact below from the disclosures made by individual banks.
Source: Basel III Disclosures, Tijori Finance
For the likes of HDFC Bank and Axis, NII impact is almost offset completely by Net Worth impact. ICICI, Kotak, IDFC First have a positive position in that aspect while even though the other banks have a negative position, the % impact seems reasonably manageable.
PSU banks: Trim down positions on rallies/ No fresh positions
PSU Banks have been the stark outperformers in the last one year (Nifty PSU Banks up 27% YTD v/s 0% returns in Nifty 50). Market sentiments continue to remain very optimistic. Broker reports have a consensus buy rating across the board and both these act as early reversal indicators in my investing framework.
PSU banks are still trading near all-time high valuations as you can see in the below chart. Yes, they still trade at lower multiples than their private counterparts, but there are fundamental reasons for the same.
The technical setup does not look bad as such especially after about 15% price decline that we have seen in the last few months. But I expect some further price correction or a longer time correction phase as far as PSU banks are concerned.
Would avoid taking any new positions in PSU Banks. I think there are better opportunities elsewhere.
Large Cap Private Banks: Reasonable valuations/ Add positions
Within the private banks, my investible set is currently focused on the top 4 large banks - HDFC Bank, ICICI Bank, Kotak Bank and Axis Bank. Federal Bank and IDFC First Bank are also credible mentions. Within this space, I find decent value.
Market sentiments have been mixed with ICICI and Axis Bank leading the index with improved performance under the new management. On the other hand, HDFC Bank-HDFC Ltd. Merger is still proving to be an overhang and Kotak Bank is reeling under the opacity over management change with Uday Kotak’s term as CEO ending next year due to RBI norms.
As far as valuations are concerned, at an aggregate level, these are trading at more comfortable levels to start building some positions. I would play it out by adding all four banks rather than taking a bet on one bank.
NBFCs: Mixed bag- Selective picks
As far as NBFCs are concerned, one would expect them to outperform if interest rates peak out and start reversing but I would not say they are out of the woods just yet. Market sentiments for NBFCs has been mixed – on one hand market participants remain concerned with the expansion of Jio Finance and on the other hand, smaller NBFCs are on the upswing of a sharp earnings cycle.
In terms of valuations, valuation in the overall NBFC space is also throwing up a mixed picture. On one end you have decadal low valuations in the gold financing companies while rich valuations persist in unproven entities.
Bajaj Finance, Muthoot Finance and Arman Financials are my top picks – each in the Large, Mid and Small cap space.
On the other end of the spectrum, I would avoid taking fresh positions in Cholamandalam Finance, IIFL Finance and Poonawala Finance. A lot of positives seem to be already priced in, for these stocks. These are trading at record valuations and despite the improvement in financials especially in case of IIFL and Poonawala, I do not find comfort in taking fresh positions in these counters. Would like to wait and watch on these counters.
I hope this write up offered a different perspective. If you enjoyed reading this and have any feedback or insights, please share by leaving a comment below. Thank you for reading, see you in the next one.
Warm Regards,
Shivam Jain
Disclosure: I’m not a SEBI Registered Investment Advisor. All content on this website is purely for educational purpose. Please consult your financial advisor before making any decision.
Comments