Small banks for big returns

"Because that's where the money is," one of America's most notorious and famed bank robbers, Willie Sutton, infamously said when asked why he robs banks. Although Sutton later confessed not ever making the witty rejoinder himself, he admitted it was something almost anybody would say. "It couldn't be more obvious." Indian equity investors will concur. They, too, have found enormous amounts of money in banking like Sutton did, albeit in more legal ways. However, the large banking stocks that earned them the big gains are now a sleepy group, ideal mostly for steady returns and low volatility. Therefore, the next round of big growth and bigger gains is to be found in small banks—particularly small finance banks (SFBs). They are fast outstripping the stodgy incumbents and are also much cheaper. Combine that with the vast opportunity size, and they look like bets where the money might be. No guts, no glory If you are a market watcher, you may be sceptical about our decision to bat for SFBs in this issue. Aren't they the hardest hit in the ongoing banking slump? Is betting on them not a high-stakes gamble? Well, you will only be partially correct. SFBs haven't found favour in the market for a while now and for good reasons. Since they serve a niche purpose—to solely meet the banking needs of the underbanked and underserved populations— their remit is extremely narrow and much more restrictive and regulated than it is for large universal banks. The risk is also higher, as they primarily lend to vulnerable segments like agriculture, micro, small and medium enterprises (MSMEs), and low-income housing. So, why consider SFBs over safer universal banks? Because their explosive growth promise eclipses the risks. They are also handily outdoing their large peers on all key growth parameters. Besides, the large scale of heavy-footed universal banks leaves little room for outsized returns that new and nimble SFBs promise. More importantly, their downturn means you can buy them for a song right now! You get the perfect mix of value and fundamentals with SFBs, which warrants a closer look at them. We detail the risks later in the story. Why pick SFBs over universal banks 1. Fast growth in a fast-growing market: The SFB industry has been growing stunningly, far outstripping the banking sector. Their advances and deposits leapt 42 and 57 per cent per annum, respectively, in the last five years ending FY23, compared to the industry's modest growth of 10 per cent over the same stretch. The outlook remains bright. SFBs' credit and deposits are projected to jump 33 per cent and 44 per cent annually between FY23 and FY25. The exponential growth is expected due to the massive opportunity for SFBs to capture a market hitherto dominated by informal lenders. As per a PwC report, while the MSME sector's credit demand was Rs 69 lakh crore as of 2022, over half of this was met through informal lending channels. The large gap means a solid opportunity for SFBs to formalise the sector. And they are capitalising on it. Many are expanding aggressively by opening branches, which has led to robust growth in recent years. As universal banks filled the credit gap in urban pockets over the past three decades, SFBs aim to repeat similar success in semi-urban and rural areas. Complete government backing for financial inclusion and financing for MSMEs is also a critical tailwind. 2. Leading the charge on key metrics: The robust demand in the underserved borrowing segment has resulted in astonishing outperformance of SFBs over universal banks on all financial metrics. SFBs have delivered a five-year median net interest margin (NIM) of 9 per cent against universal banks' paltry 3 per cent. They have also excelled in terms of returns on equity (ROE). The industry's five-year average ROE was around a robust 14 per cent versus just 9 per cent for universal banks (excluding the top five banks by advances). The higher return ratios result from the high interest rates SFBs charge borrowers to compensate for the steep risks they assume. 3. Touting a clean bill of health: Asset quality can make or break a bank. And SFBs are also head and shoulders above most universal banks on this metric. The recovery has been astounding after the deadly NPA mess during the Covid pandemic, which saw their average gross non-performing asset or GNPA ratio touching a dreadful high of 6 per cent in FY22. The average GNPA ratio of SFBs is now down to 2.7 per cent and continues to be on the mend. The improvement resulted from concerted efforts and the gradual improvement in borrowers' cash flows, which led to recoveries and sizable write-offs. By comparison, most universal banks (excluding the top five) continue to have elevated GNPAs at an average of 3.3 per cent despite diversified loan books. Regarding SFBs, rating agency ICRA expects the industry to report steady GNPAs of 1.8-2.2 per cent by March 2025. 4. The best bargains: In the current hot market where value is hard to come by, SFBs stand out. The solid financial performance, meaningful recovery in asset quality, and promise of growth have yet to translate into stock gains. That should be viewed against banks' overall muted performance in the last few years due to sluggish deposit growth, which has widened the credit-deposit gap. However, as soon as the mismatch reduces and investor attention turns back to the banking sector, SFBs will likely be the first to benefit. Seven of the eight are trading below their respective median P/B ratios (based on five-year data or since listing, whichever is earlier). Apart from AU Small Finance Bank, none trade at a P/B ratio of more than 2! You get to snap them up at a steal. Universal banks offer a less impressive proposition. These stocks, while also low-valued, are cheaper mainly for

This article was originally published on November 05, 2024.