It’s unfortunate that banking sector has lost investors & depositors trust and appetite in 2019-2020 when dynamics turned from bad to worse post start of NPA woes since mid FY19, leading to Banks losing momentum on growth rate across productivity, profitability and efficiency, resulting in unwind of valuation and market cap by 65-90% between H1/2018 to March H2/2020. The worst hit was on YES Bank that had to be bailed-in by SBI, while most others in struggle to stay afloat. Having discussed in detail on the “how & why” part of it in the earlier blog (published before release of restructuring scheme for C-19 moratorium loans), let’s assess the way forward for medium term positioning for the investor community, that can’t shy away from banking sector allocation.
Position on high-value stocks:
The study has to obviously begin with Big2 high value stocks – HDFC Bank and Kotak Mahindra Bank, both have clearly weathered the storm with prudent banking and being conservative on high risk – high yield – high fee credit & non-SLR investments portfolios. If portfolio risk-weight need to be maintained at above-par level, allocation of minimum 25% (12.5% each) is necessary despite elevated P/BV of 3.5% (PE at 20-30%), which is significantly lower from the high multiples that they commanded from the investors community. Given that RBI is yet to take favourable view on dividend payment for FY21 & beyond, it’s good on book value even on declining PAT scenario given their high PAT even during tough times. The positive take-away are from (a) comfort on CET-1 without dependence on AT-1 or Tier 2 bonds (b) well positioned on cost of funds to be competitive on acquiring AAA/AA risk borrowers (c) stability on NII & fee income despite growth contraction and credit risk aversion to sub-investment grade & unsecured exposures (d) sign of turning risk-neutral (from aversion) to systemic important high risk sectors with intent to be participative to turnaround (e) advantage from ability to sustain low paid-up equity as percentage of net worth/Book value arresting downside risk on ROCE/EPS from earnings pressure. All combined, both stocks have high degree of safety to be categorised as low risk – moderate reward stocks.
HDFC Bank CMP around 1100 is not away from 52 week high of 1305 (behind by only 20%) but significantly below all-time high 1985 (of February 2018) with minimum upside potential of 80% when GDP expansion is restored. It was good entry point around 1000 (50% value erosion from all-time high) for buy & hold for H1/FY22 target 1350. So, good to retain buy on dips strategy at 950-1050 for 1350-2000. It’s prudent to have a stop at 925, despite being one of the top 3 to hold as permanent stock in the portfolio.
Kotak Mahindra Bank is unique in a way that the stock didn’t participate in value de-rating between February 2018 to February 2020 to hit peak of 1740 before Covid-19 collapse to 1000 followed by consolidation at 1300-1450. KMB is relatively better than HDFC Bank on NPA with minimal downside risk from retail & unsecured credit portfolio. Given the ability to absorb NPA woes from deep pockets and capabilities to arrest earnings squeeze, investors will like to hold KMB in their portfolio, hence see value-buy appetite at 1185-1285 (CMP at 1320) with stop below 1150. KMB is one of top 3 stocks for perpetual holding given the combination of clean book, high on efficiency & prudence, conservative on Credit & non-SLR investments portfolios and best in class risk, compliance and governance standards despite double-hat of major shareholder as head of the management. The strategy to share wealth with domestic investors rather than give away to foreign investors provides the price stability when FPIs gets into exit mode. It may not be an exaggeration to say that KMB stock is darling of both retail & wholesale investors, pushing Uday Kotak into top end of wealthy Indians in span of 15 years since launch of the Bank in 2004. It’s an extraordinary success story scripted & directed by Uday Kotak with solid (but little known) team that have stood with him for decades – different from what Aditya Puri built with HDFC support. Investors will like KMB stock despite emerging Key Man Risk at the top management.
High on systemic importance from supporting economic asset creation
Focus in this segment are the systemic important banks on the assets side of the balance sheet – State Bank of India, ICICI Bank and Axis Bank that participated heavily for economic capacity creation & expansion since 2004. They are the lead banks for most of high value lending to corporate India across all sectors, taking the best & worst on their books. Why it’s important to hold these stocks in the portfolio? (a) will continue to maintain dominant position in project & asset financing of large borrowers, high on productivity (b) will have NII advantage from lower cost of funds & relatively higher yield (c) higher fee income post cut-off of flow to non & marginal lenders accessing current account & fee based income from sourcing non-credit products without much skin in the game from credit exposure (d) reciprocal support from Finance Ministry diverting CA float and fee based income (e) ability to raise AT-1 and Tier 2 bonds, avoiding increase of paid-up capital to preserve EPS. The downside risk obviously is from relatively higher credit cost despite mitigation from revenue support & improved account profitability. All combined, it’s good to allocate 25% of portfolio to this category, SBI (12.5%) , ICICI (7.5%) and Axis Bank (5%).
SBI, being the daddy of banking sector got the moves differently, peaked out in July 2019 at 374 before sliding down to 150 in May 2020 before consolidation at 150-250 with recovery high at 231. While the strategy was to stay in back & forth at 185-235, it’s good for buy & hold at 150-185 given the upside potential of 100% to bridge the gap with all-time high and beyond in FY23. Good to take additional comfort on SBI from being the single largest beneficiary on RAROC from acquisition of credit & non-SLR investment portfolio with back-stop and 20-100% credit underwriting schemes of the exchequer.
ICICI Bank had gone through rough patch for wrong reasons with emphasis on growth & size (productivity) compromising on risk, compliance and governance. This is behind now, and time to look ahead given its contribution and hunger for economic capacity creation. It’s been 552-268-422 moves between December 2019 and August 2020, finding support around 350 (CMP ~370) with base at 300-325. It’s buy on dips strategy at 325-350 (stop at 300) for recovery into 422-522.
Axis Bank lost heavily between June 2019-March 2020 from 826 to 285 before sharp recovery to 533 by August 2020. Despite the Bank going low profile post change of leadership, it’s need to be seen as phase of confidence building to get back into peak. Given the base support at 275-300, good to accumulate here while in the chase for over 500. What’s the differentiator with SBI and ICICI Bank? It’s existence of relatively better level of competency at senior level management and fleet footed speed to be ahead of the competition. This stock could emerge as the trump card, and till confirmation, good to start with lower allocation before scaling up.
Spotlight on 4 PSU banks that would emerge to strengthen PSU banks market share
The decision of Finance Ministry to promote 5 PSU banks as systemic important banks, while giving away majority stake to private entities on 7 banks turns spotlight on BOB, PNB, Canara Bank and Union Bank of India that would be in state-owned category along with SBI. Why bet monies on these banks? (a) momentum on gaining market share on financial intermediation will lead to significant top-line growth on deposits & advances (b) significant growth in (ex-NPA provision) earnings from ability to access low-cost funds for deployment in high-yield loans (c) availability of backstop & credit underwriting support from Finance Ministry giving better RAROC (d) cheap to acquire valuation trading at deep discount to book value (e) ability to raise AT-1 and Tier 2 bonds to avoid beyond necessary increase in paid-up capital. Given the possibility of significant upside performance against manageable downside risks, it’s prudent to have exposure of 7.5% each on BOB & PNB and 5% each on Canara Bank & Union Bank of India.
All these 4 stocks are beaten down stocks with no correlation or alignment with others. But CMP of BOB at 45 (off from 5 year high over 200 against May 2020 low 36) sets up buy on dips mode at 35-45. PNB collapsed from 3 year high over 200 to May 2020 low 26 with CMP at 33, and good to be in buy on dips mode at 26-33. Canara Bank down from 3 year high of 463 (October 2017) to 74 (March 2020) with recovery into 120. While CMP around 100, it would be good buy for hold set up at 75-95 for recovery over 120 beyond FY22. Union Bank of India is no better, pushed down from 205 (May 2017) to 22.65 (May 2020) to 36.55 before stability around 30, and would find appetite at 23-29. Need to note that investment of 25% of portfolio in these 4 banks is with long term horizon of over 3-5 years in anticipation of support from exchequer to strengthen performance and valuation of PSU banks, building 50-65% market share for 5 PSU banks (including SBI), leaving out the balance to new & old generation private sector banks.
What’s the investment strategy beyond 5 PSU banks and 4 new generation private sector banks?
Having allotted 75% portfolio risk-weight on 9 banks where RR is relatively better, need to split the balance 25% between PSU banks that would be privatised (opening up opportunity for short term gains) and left-behind new & old generation private sector banks as proactive investment strategy, which means that these stocks are not for buy & hold but to get engaged in back & forth swing trades to encash extreme one-way volatility providing astronomical returns than the banks that are held for long term value investments. For this agenda, it’s not prudent to look beyond index stocks – IndusInd Bank, Federal Bank, Bandhan Bank, IDFC-First Bank and RBL.
IndusInd Bank stock de-rating from August 2018 high 2038 (and 52 week high 1596 to March 2020 low 235) by 88% knocked out investors trust on the stock. There after recovery to 712 (in August) by whopping 200% followed by push back to 588 sets up fear of volatility rather than comfort from stability, with book value volatility at 0.5-1.5. Another phenomenon is the trust deficit from depositors post YES Bank bail-in reconstruction. Both combined, while Institutional Investors (domestic & foreign) are into sell on recovery from fear that worst is not behind and depositors either look for higher premium or restrict exposure to ₹5 lacs of insurance coverage. What’s outlook? (a) there’s no clarity on combination of pre & post Covid-19 NPA position when the hit is expected to be from all corners – wholesale book (Corporate & Project Finance), Vehicle Finance, non-vehicle retail and recently acquired Micro Finance (b) earnings squeeze from the need to pay higher risk premium for deposits and refraining from high yield & high fee credit business (c) temporary shift to top-line contraction pushing the base productivity behind by 3-5 years (d) given the tough market for AT-1 and Tier 2, high dependent on increasing paid-up capital against low share premium, which may not be EPS positive as before (e) lack of visibility on competency and expertise of top & senior management to weather crisis situations. So, where to buy for swing trade? The strategy since start of 2020 is on down-hill chase to target 200-350 (building momentum on break down at 1000-1150) followed by consolidation at 450-600, but surprised with momentary overshoot over 700 post UBS buy recommendation, which is now undone with push back into 585-620. Let’s stay aside for below 585-620 while investors lighten portfolio at 635-700 (when low probability above 712). There could be unpleasant surprises starting Q2/FY21 results through Q4. When Index has come off from 25200-25350 to 22000-22150 retaining downside risks into 17500-21000, see swing trade entry point at lower end of 450/485-665/700, while awaiting below 350 for value buy & hold appetite for exit at 700.
Federal Bank as leader of old generation private sector bank has dismal market cap of ~10K Crores at sub-par P/BV of 0.7, losing value since October 2017 high 127 to March 2020 low 36 by 250% and now building breakdown pressure at 50-65. It’s good swing trade set up at 40-60 with stop at 35 or 65 for 1:4 RR. Here again, need clarity on profitability and CAR (adjusted for higher provision & earning squeeze) and source of cost efficient capital to get into long term value-buy mode.
Bandhan Bank established well in quick time with current market cap of over ₹50K Crores at P/BV of over 3, at par with HDFC and KMB on enterprise valuation. Stock is significantly down from August 2018 high 741 to March 2020 low 152 before recovery to 402 for consolidation now at 285-320. The major advantage for the Bank is very high NII post conversion of operations from Micro Finance NBFC to Universal Bank and fee income from cross-sell opportunities from large customer base. The downside risk is the uncertainty on credit cost (from high risk micro finance and retail business loans which are largely unsecured) despite having better bandwidth from elevated yield on loans. There’s no issue on capital raising at 3+ Book value. Only irritant for buy & hold investors is its inability to emerge as universal bank, being in comfort zone akin to Small Finance Bank. It would need makeover from SFB to Universal Bank to get price focus to over 700 for 5-7 P/BV. Till better clarity on Covid-19 moratorium book, good to watch support at 270-285 with stop below 250 for first target 400. Between Bandhan Bank and IndusInd Bank (with similar market cap), Investors preference could be biased to Bandhan Bank (despite higher P/BV) given high NIM and ability to absorb elevated credit cost.
There’s no real clarity on RBL and IDFC First Bank at sub ₹10K market cap and at P/BV of 0.50-0.65%. It would have been great stocks to buy if the economy is in growth mode as-in 2008-2018, but given the uncertainties, it’s tough for medium & small banks to absorb earnings and capital impact to stay in business. So, the agenda for 25% of the portfolio is to stay in 15% cash with trading portfolio allocation of 5% each on IndusInd Bank and Bandhan Bank and stay aside for now on Federal Bank, while 15% cash to be used for short term opportunities in “to be privatised” 7 PSU banks and banks that are not covered in this review, including IDBI Bank and YES Bank which are heavy on paid-up capital with relatively lower PAT, which may not be investors envy for longer term.
What’s the immediate way-forward execution strategy?
When there’s no turnaround signs on the big picture, it’s good to be in wait & watch mode. There are umpteen number of issues that need immediate resolution when into top-line contraction despite being an essential service during the lockdown phase. It’s less said the better on bottom-line, declining PAT from rising NPA provision, loss of m2m advantage on investment book and rising cost-income ratio from declining non-interest income. All these are covered in NIFTY Bank index valuation (gross under performance to NIFTY index) and in extreme volatility between 16000/19500-22000/25500, and would need stability at 19500-22000 to provide comfort for buy & hold initiation.
Banking Sector can’t be ignored by the Government to make up for GDP contraction between FY20 to FY22, wiping out 2 years of productivity & revenues. It’s already too late to delay any further. The identified 4 PSU banks (except SBI) need support from combination of recapitalisation and credit underwriting for better CAR and NPA, that would be followed by uptrend in PAT and EPS. 4 new generation private sector banks have the capacity to fend for themselves, making it Big9 to take economy beyond FY22, building scale on GDP growth momentum. Need close watch on IDBI Bank to get into Top-10 banks (Tier-1 banks) that could cover minimum 75% of market share.
What about foreign banks contribution? Going forward foreign banks presence as branch offices wouldn’t work, unfortunately most are not ready to buy-in the WOS concept operating as domestic SCB with backstop from head office balance sheet. DBS is the bank to watch for as competitor to the Big4 private banks, while SBM will take a long while to come into the radar holding very heavy capital (paid-up of ₹750-800 Crores) against PAT of <0.25% of net worth of ~550 Crores.
At this point, it’s only hope that banking sector get to see light at the end of the tunnel soon, not later than end of Q4/FY21 when there would be clarity both pre & post Covid-19 NPA position and the impact of FY21 GDP contraction on credit growth and profitability. The unknown angel for the banking sector is recovery from NPA provisions that would add direct to P&L account, which got diluted from Covid-19 cash flow impact. In the meanwhile, RBI has done its best with some first of its kind supportive measures, keeping the sector afloat. It’s time for the Government to act big & fast to avoid regret!
Best wishes, stay safe!
Moses Harding
