The banking sector has been on a roll for the past couple of years, throwing up huge opportunities for wealth creation. Sample this: if you had invested Rs 1 lakh in the banking index in May 2007, you would have earned around Rs 1.9 lakh today at a compounded annual growth rate, or CAGR, of 18 per cent. In comparison, if you had invested the same amount in the Nifty index, you would have got Rs 1.3 lakh at a CAGR of 7 per cent .
As the Indian economy is doing well with over eight per cent growth rate, banks tend to be one of the biggest beneficiaries because of the demand for credit. Besides, market conditions are suitable for growing the loan book.
In fact, after the slowdown in 2008 and 2009, the banking index delivered a return of 82 per cent (in the period between May 2009 and October 2010), compared to a return of 40 per cent delivered by the broader market. "In 2009/2010, banking was the safest bet, as people had concerns about investing in sectors such as telecom, power, real estate, oil and gas," says Ajay Parmar, Head of Institutional Research, Emkay Global Financial Services.
This is also due to the strong credit quality of Indian banks, which made them resilient during the global crisis. During this period (May 2009 till October 2010), the returns delivered by the public sector banks, or PSBs, index were much stronger at 110 per cent. This can be attributed to the fl ight to safety away from other assets into PSB deposits along with healthy credit growth. Further, PSBs have large holdings in government securities and bonds with a longer maturity period, which have done well since the yield on the 10-year benchmark came down from 9.5 per cent to 5.5 per cent in March 2009.Bumpy road ahead
Banking stocks, however, have been beaten down due to reduced credit offtake, pressure on yields, which is fl owing into valuations causing downgrades in this sector. Since November 2010, these stocks have delivered a return of -19 per cent compared to -13 per cent for the Nifty. The PSB index has performed even worse with a return of -29 per cent. With the Reserve Bank of India, or RBI, raising its key policy rates by 250 basis points since March 2010, there has been an overall increase in the lending and deposit rates.
Although a bank can generate revenue in a number of ways, its main income is through interest on the money it lends. As interest rates rise, credit growth tends to slow down due to higher borrowing costs. In fact, credit growth has moderated from 23.3 per cent in January this year to 21.9 per cent in April. The deposit growth has inched up from 16 per cent in January to 17.9 per cent in April.
Despite this, some private sector banks' performance is not that bad. "Although the results declared by banks have been a mixed bag so far and there are pressures on margins for several banks, credit growth has remained strong," says Dipen Shah, Senior Vice President, Kotak Securities. ICICI Bank posted a strong loan growth at 19.4 per cent y/y and 4.7 per cent q/q, while margins improved from 2.6 per cent to 2.7 per cent partly due to premature breaking of fi xed deposits. Banks such as HDFC Bank and Axis Bank have been able to grow profi ts despite the high interest rate scenario, says Rajeev Thakkar, Chief Executive Offi cer, Parag Parikh Financial Advisory Services.
Axis Bank posted a strong loan growth of 36 per cent year on year, and maintains a guidance of 25 per cent growth going forward. Thakkar maintains a buy on Axis Bank at the current price with a three-year perspective.
However, the biggest disappointment has stemmed from the public sector behemoth SBI, which declared a 99 per cent drop in profit for the quarter ended March 31, due to provisioning (an expense set aside as an allowance for bad loans) on teaser loans, providing for pension and gratuity shortfall and higher non-performing assets, or NPA, has shaken the markets. "The bank's Q4 net interest margin fell to 3.07 per cent in comparison to 3.61 per cent in the previous quarter. The bank's pension liability provision was much higher, which likely reduced the book value by about Rs 125 per share," says Shah of Kotak. This could be a precursor for similar things happening in other banks, especially PSBs, which are saddled with the same issues.
According to Parmar of Emkay Securities, banks have been cautious about their growth and their aim is to maintain the net interest margin and quality of assets. Most banks have toned down their growth assumption for 2011/12 to 20 per cent in loan books compared to 25 to 27 per cent earlier. "Although spreads of banks have been quite stable since the last three quarters, this will unlikely to continue for long and that will affect their profi t growth," says Anand Shanbhag, Executive Director and Head of Research, Avendus Securities.
In 2010 and early 2011, banks benefi ted largely from the lag in repricing of deposits, which resulted in the net interest margin expansion, or NIM. A majority of loans that banks offer effectively carry fl oating rates. Therefore, when the rates are rising, the fl oating interest rates are revised immediately. However, the average cost of deposits does not change that rapidly.
According to Thakkar, infl ation and interest rates are likely to remain elevated for some time because of easy monetary and fi scal policies in developed countries. Also, supply side constraints and disruptions in commodities like oil are also contributing to the infl ationary scenario. Public Sector Banks Score Low In its annual monetary policy, the RBI increased the provisioning on substandard assets from 10 per cent to 15 per cent, doubtful loans from 20 per cent to 25 per cent.
It also asked the banks to provide 2 per cent on restructured loans. In this context, PSBs are negatively placed, as restructured loans form almost 5 per cent of their total loans. Private sector banks are better placed at less than one per cent.
According to a recent report by Espirito Santo Securities, restructured loans were as high as 6.5 per cent for Punjab National Bank and 4.5 per cent for SBI compared to 0.16 per cent for IndusInd Bank and less than 0.3 per cent for YES Bank and HDFC Bank. Shah of Kotak Securities says growth rates of private sector banks are expected to be higher than those of PSBs, because of their focus.
"Private sector banks will have lower NPAs and may face lower slippage on restructured books," he adds. RBI has also increased the savings bank deposit rate by 50 basis points. According to Espirito, this will increase the cost of deposits for large PSBs and private sector banks by 10 to 15 basis points and a one to fi ve basis points impact on deposit costs of new-age banks like YES Bank and IndusInd Bank, because of their relatively low proportion of current account-savings account, or CASA, deposits (less than 10 per cent).Watch out for underperformers
Parmar recommends selling stocks like Canara Bank due to its low CASA and rising NPA issues. He expects SBI and Union Bank to underperform considering the changing environment for these stocks. Shanbhag advises investors to refrain from investing in this sector right now. "One should ideally wait for next two months. By then, there will be more clarity on macroeconomic issues such as infl ation, corporate results or any announcement from the regulator on further monetary policy tightening."
For an investment horizon of more than 12 months, Shanbhag recommends PSBs supported by their high-teens CAGR in earnings, even after adjusting forecasts for the likely rise in non-performing loan, or NPL, provisions and staff costs. For the long term, Shanbhag likes stocks such as PNB because of its high return on equity, and Bank of Baroda for its relatively low NPL ratios and higher return on equity.
Among the new private banks, top picks remain IndusInd Bank and Axis Bank, which are likely to perform well.