The BSE Bankex has outperformed the Sensex by a large margin over the one-year span. The banking sector is likely to continue doing well in the medium term as well, says J Venkatesan, equity fund manager at Sundaram BNP Paribas Mutual Fund who manages the Financial Services Opportunities Fund at the fund house. In particular, he is bullish about the prospects of public-sector banks which, he says, offer good growth prospects and are also available at attractive valuations. Excerpts from an interview with Sanjay Kumar Singh:
On August 16, 2010, the Sensex showed a one-year return of 22 per cent while the BSE Bankex showed a one-year return of 52 per cent, amounting to an outperformance of 30 percentage points. What are some of the reasons for this outperformance?
There are many reasons for this outperformance. The financial sector is a clear proxy for India's economy. With the economy turning buoyant, the sector got re-rated more. The sector did underperform significantly during 2008 on account of the global financial crisis, farm loan waiver, and credit concerns. Hence with the environment improving it did some catching up.
Now the credit cycle is behind us and even the interest-rate cycle is getting near the peak. Further, Indian financials have shown good earnings growth along with loan growth. On the other hand, global financials have shown loan book growth but not significant earnings growth due to severe strain on their profitability.
Further, state-owned banks have undergone a structural improvement in performance over the years. They have started exhibiting growth rates similar to those of private banks. With their strong liability franchise, their net interest margins (NIMs) are expanding. Their market share in core fee income is improving. Their cost to assets is better than that of their private-sector peers. Even employee productivity has improved significantly. On parameters such as business per employee, their performance is at par with that of their private-sector peers now.
Their earnings quality has improved in the sense that the contribution to profits from investment and mark-to-market gains have come down, signifying that their core banking profits (net interest income and fee income) contribute the majority of their earnings.
All these factors have contributed to the sector's outperformance.
Will this outperformance continue? How are the prospects of this sector over the next two to three years?
We think that this outperformance will continue in the medium term. Despite the recent outperformance, public-sector banks are going at 1.3 times price to book while having return on equity (RoE) of about 20 per cent. The overall market is at 3.5 times price to book with RoE of about 17 per cent. While we cannot compare the two as the dynamics are different, we can still see that the banking sector offers reasonable earnings growth, generates reasonable RoE, and is available at an attractive price to book multiple. There could be a case for re-rating of PSU banks still, given the structural changes we discussed earlier.
Private banks, on the other hand, offer much better growth prospects. Hence from the growth perspective they look interesting.
What are some of the potential threats to the banking sector?
The same factors that threaten the economy pose threats to this sector as well. India, being a twin-deficit country that imports two-thirds of its energy requirements, might get impacted if foreign flows reverse and crude goes beyond unreasonable levels. Moreover, if we get into another severe credit cycle, the sector could underperform.
What impact is the current tight liquidity situation having on banks' operations? Could it dent their profitability or does it work to their benefit?
The current tight liquidity will ease going forward. Deposits growth, which is currently languishing at 14 per cent, will also improve going forward. We believe that foreign flows will continue as India offers strong growth opportunities. We do not think that the current tight liquidity will have a big impact on profitability as the situation may not last long.
If the sovereign debt problem in Europe flares up, and there is tightening of liquidity internationally, would it have a negative impact on Indian banks' profitability?
If the debt problem flares up, there would be further infusion of liquidity by central banks. Only about four banks have significant exposure to international operations. The sector may not see a big negative impact if global conditions worsen. But the secondary impact on the overall economy would need to be watched.
As you mentioned, deposit mobilisation is lagging compared to credit growth rate. Banks are expected to hike their deposit rates (some have already done so). What impact will this have on banks' net interest margins? Will banks be able to maintain their NIMs or will it shrink?
When interest rates go up in the system, typically cost of funds grows less than the yield on advances because certain portion of banks' liabilities are in the form of current and savings accounts. Having said this, it also depends on which gets re-priced faster. With the base rate mechanism in place and banks raising their PLR also, we do not expect NIMs to shrink.
What are the pros and cons of investing in private sector banks at present?
Private sector banks are also an attractive place to be in. They offer good earnings growth story. Some of them focus on niche asset classes and earn superior returns on them. India being underpenetrated in terms of banking, they are able to cherry pick their assets and earn good returns. But private bank stocks do not come cheap. From hereon re-rating will be difficult, but they will offer returns in line with their growth rates.
And what are the pros and cons of investing in the public sector banking space?
The public sector banks, as I said earlier, offer value and earnings growth story. The banking system could move into system-driven Non Performing Assets (NPA) recognition method wherein we could get temporary increase in credit costs in the case of PSU banks.
What are some of the characteristics, in your opinion, that investors should look for when investing in a banking stock?
Our belief has been that one should view the sector as a long-term wealth generator in a developing economy like ours. Any banking company with proper systems and good risk management practices in place will emerge a winner at the end of the day. Hence the key characteristics to look for are the systems, and proactive management that drives the bank's growth.
Interest-rate cycles and credit cycles keep happening over a long span of time. An investor could time his entry and exit from the sector by keeping an eye on these cycles. In the process he could improve his returns significantly.
What should one specifically avoid or watch out for when investing in bank stocks?
While investing in banking stocks, one should consider the strength of their liability franchise and also the asset classes they hold. In certain classes of assets like auto financing, we have seen irrational pricing being pursued by players at times. Housing mortgages have lesser credit costs but create asset-liability mismatch. Heavy investment in any particular sector could get a bank into trouble if the sector gets into a bearish phase of the business cycle. As said earlier, one should also look into the overall state of the company while investing in banking stocks.
Have valuations become rich in this sector, especially for private banks?
Valuations are still reasonable for public sector banks. For private sector banks, the valuations are becoming rich but they still offer good growth opportunities and hence this is an attractive place to be in.