High Growth, High Valuations | Value Research Though the banking sector is expected to perform well in this phase of rapid credit growth, invest selectively as valuations have turned rich
Special Report

High Growth, High Valuations

Though the banking sector is expected to perform well in this phase of rapid credit growth, invest selectively as valuations have turned rich

After infrastructure, banking is the sector that the maximum number of fund managers are bullish about today. As the economic recovery gathers speed, credit demand from corporates will rise. Moreover, when an economic expansion is underway, banks tend to suffer less on account of bad loans. For these reasons the banking sector is in a sweet spot today.

The positives
Strong credit demand. In this credit cycle, credit growth is expected to rise above 20 per cent (according to RBI's recent policy review, it has already touched 19.4 per cent y-o-y). The government's emphasis on infrastructure development; high demand for funds from corporates to meet their working capital needs and to fund their capex plans; and high demand from the retail segment, especially housing and auto loans are factors that are expected to result in high demand for credit.

At present the repo rate is at 6 per cent. This is still a low rate in absolute terms. Interest rates are expected to rise by another 25-50 basis points this financial year as inflation remains a concern. But even if rates are rising, the demand for credit is unlikely to be affected, provided they rise gradually. (Corporates will not mind borrowing money at a slightly higher cost in an environment where their business is expanding.)

What happened during the last credit upcycle between FY06 and FY08 supports the contention that rising rates will not affect credit demand. Between January 2006 and June 2007, SBI hiked its prime lending rate (PLR) from 10.25 per cent to 12.75 per cent. Nonetheless its credit growth remained strong at 27-34 per cent.

Since liquidity conditions are tight at present, this gives pricing power to banks, enabling them to raise loan rates without fear of contraction in credit demand. In particular, those banks which have mostly given out floating-rate loans, will be able to re-price their loans and thus maintain their net interest margin.

Investment portfolio unlikely to take a hit. Public sector banks have reduced their exposure to interest sensitive high-duration bonds. So even if interest rates rise their investment portfolios will not take a big hit.

NPL-related concerns are declining. A few banks suffered high slippages during Q1FY11, leading to concerns about asset quality. However, after Q3FY11 NPLs (non-performing loans) are likely to decline as relapse of restructured assets will have peaked by then. Slippages from the normal portfolio are also expected to come down because of better corporate earnings and improving balance sheets. In fact, NPL recoveries may even pick up because of improving cash flows of corporates. (Between FY04 and FY08, when economic growth was robust, banks' slippages as well as recoveries had improved.)

Many banks will soon migrate from manual recognition of NPLs to system-based recognition based on CBS technology. Initially it was feared that this might lead to higher NPLs. However, Siddharth Teli, analyst at Religare Capital Markets, says in a recent report that this is unlikely to be the case.

Capital position is comfortable. Most Indian banks are comfortably placed regarding capital adequacy: their tier one capital ranged from 10-12 per cent at the end of FY10. Private sector banks have already raised capital in order to fund future growth. PSU banks have largely depended on internal accruals because they need government permission for stake dilution. The government may infuse capital in a few public sector banks. This will reduce the leverage on their balance sheets.

The negatives
Low deposit growth. Deposit growth has not picked up in tandem with credit growth. According to the September 16 policy review statement from RBI, it stands at 14.4 per cent y-o-y. This is owing to lower rates offered by banks on deposits. Earlier, large banks like SBI had a lot of excess liquidity available with them. So they did not want to hike their deposit rates in order to attract more money. But this has begun to change. Banks are now hiking deposit rates in order to attract more funds as credit demand has shot up.

Operating leverage largely played out. PSU banks have done a good job of reining in costs. This has been the result of implementation of Core Banking Solution (CBS) which has raised productivity. But there will be little room for improvement in productivity from current levels.

Fee income growth to be muted. Fee income growth will be low chiefly because of an already high base and also due to unfavourable regulatory changes. Changes in Ulip norms could hit bancassurance revenues. The removal of entry load on mutual funds will also affect banks' earnings. All these developments will prove more damaging to private-sector players.

High valuations. There has been a big rally in bank stocks over the past two months. Many banking stocks are trading close to their five-year high valuations. Although earnings are expected to be steady over the next few quarters, one needs to carefully choose stocks in this sector because of their high valuations.

What should you do?
Look for banks with superior deposit franchise. As interest rates move higher, banks' ability to maintain their net interest margin begins to get affected. While they are forced to re-price deposit rates (due to competitive pressures), it becomes more difficult to re-price loan rates higher (credit demand begins to get affected). In such a scenario, it is better to invest in banks that have access to low-cost deposits, which means banks that have a high current account savings account (CASA) ratio. Banks with access to low-cost deposits are better able to maintain their margins. Banks with larger branch networks have a higher CASA ratio.

Go for banks with a higher proportion of floating loans. Banks typically re-price their loans faster than their deposits. So initially they tend to benefit from a rise in interest rates. But only banks that in the past have made more floating-rate loans will enjoy the flexibility to re-price existing loans.

Moreover, banks have higher pricing power in segments like retail and small and medium enterprises (SMEs), and less in segments like infrastructure. Banks that lend mostly to mid- and large-sized corporates also have lower pricing power as the latter can resort to external commercial borrowings (ECBs) when banks' loan rates rise.

Banks that have a favourable asset-liability mix include SBI, HDFC, Axis and PNB.

Be selective. Over the last one year the BSE Bankex has gone up by 45.69 per cent while the Sensex has gone up by only 17.25 per cent (September 17 data). The rally has been especially sharp in the last three months. So valuations of Indian banks are between their median and peak valuations during the last credit cycle (FY06-FY08). Many are today trading above their five-year average P/B multiple. PSU banks have also got re-rated due to improvement in their return on equity (RoE) and stable asset quality.

Though the fundamentals remain robust, you need to be selective on account of high valuations. Expansion of net interest margin will now be difficult. Any disappointment on earnings or higher-than expected bad loans could lead to a sharp correction.

Finally, opt for banks that have a superior deposit franchise (high CASA ratio) rather than those that depend on bulk deposits; low asset quality risk; and reasonable valuations.

The positives

  • Strong economic growth will lead to high credit demand
  • Concerns about bad loans are declining
  • Liquidity is tight, which will give pricing power to banks
  • Higher deposit rates will help banks attract more deposits

Current valuation mostly exceeds historic median
  Ownership group  5-Y Median P/B  Current P/B
Allahabad Bank PSU 1.06 1.78
Bank Of Baroda PSU 1.15 2.21
Bank Of India PSU 1.49 1.88
Canara Bank PSU 1.27 2.28
Indian Overseas Bank PSU 1.48 1.38
Oriental Bank Of Commerce PSU 0.95 1.66
Punjab National Bank PSU 1.59 2.33
State Bank Of India PSU 1.91 3.05
Union Bank Of India PSU 1.47 2.00
Axis Bank  Private  3.22 3.64
Federal Bank Private  1.23 1.68
HDFC Bank Private  4.38 6.23
ICICI Bank Private  2.13 2.67
Indusind Bank Private  1.75 3.63
Karnataka Bank Private  1.2 1.44
Kotak Mahindra Bank Private  6.65 5.72
Yes Bank Private  3.64 3.75
Current P/B as on October 08,2010

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