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What To Do With Financial Stocks Now?

Financial stocks are rocking the markets. But not all stocks are likely to do well. Here’s how to select the winners

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Banking and financial stocks are the darlings of the stock market. Over the past few years, banking stocks have delivered spectacular returns to investors. The Bank Nifty has returned 18 per cent in the last one year, while the public sector bank index has delivered 3.1 per cent. Banking delivered bigger returns in the last six months i.e. 29 per cent for Bank Nifty, and 35.5 per cent on PSU Bank index.

Even stocks that are not a part of the frontline indices are delivering fantastic returns such as those in micro-finance and in non-banking financial services. But the larger question now is: will the financial-services sector continue to deliver returns?

“Financial services stocks are moving for completely different reasons, and therefore one set of reasons do not apply to the entire sector,” says Clyton Fernandes, banking analyst at Systematix Shares and Stocks. “Public sector banks are moving for various reasons; so too the micro-finance sector and the private sector banking space. And they will continue to move for different reasons, hence investors will have to determine the varied factors. But financial-services stocks have reached fair valuations on a broader level. Still, there is scope for some stocks,” avers Fernandes.

Given that various factors are at play in the banking space, investors will have to find reassurance from business models, the possibility of growth, and current valuations. And, carefully distinguish between the different business models.

Besides, banking and financial sector stocks often tend to move faster than market averages. Says Alok Shah, banking analyst, Centrum Broking: “Banking is a high beta sector, and the factors driving it vary; hence, investment in them has to be for different reasons. Public sector banks, for example, are more tactical plays due to changes in their business environment.”

But, there is no doubt that investors need financial services stocks in their portfolios. With more than a 26 per cent weight in the frontline Nifty, banking stocks are playing a crucial role in the direction of the market — and have become an almost perfect proxy for the fortunes of the economy. So, if the economy is not doing well, financial services stocks reflect rising non-performing loans; and, if it is doing well, growth rates and credit offtakes rise correspondingly.

Besides, banking will always be a favourite for many more reasons. Says Fernandes: “Banks are highly liquid. They appeal to all kinds of investors because they are Board driven organisations. This adds to the charm of owning banking stocks.”

Delving into the reasons why financial services stocks are zooming, it becomes clear that micro-finance companies are doing well because of their high growth, management quality, and the possibility of faster growth ahead. Some NBFCs have also shown great growth features, particularly companies such as Bajaj Finance.

Consumer lending has grown because turnaround time earlier was two or three days. Says Fernandes: “Nowadays, spontaneous purchases need spontaneous financing, and many banks were not offering this facility. This opened up opportunities for Bajaj Finance, which invested heavily in back-office systems and brought the turnaround time in loan disbursements to less than a day. However, as the stock has now run up considerably, for meaningful returns investors will probably have to hold the counter for much longer.”

You have seen the stocks of micro-finance companies such as SKS MicroFinance and Satin Credit, and those of small banks such as Ujjivan Financial Services and Equitas Holdings doing very well on the bourses because they are a combination of high profitability and high growth.

In the case of public-sector banks, while earnings have been hit badly because of their NPAs, investor expectations have not changed because of the RBI’s asset quality review, which was conducted in the last two quarters last year. People are expecting that, at least, the asset-quality review in the next quarter will not get any worse because the worst is now behind. The government, on its part, reiterated that it would support the banks.

In banking, finding your niche and putting in place the levers for growth are crucial to drive spreads. In certain sub-segments such as microfinance, commercial vehicle lending, or even infrastructure, are some areas that are very specialized and niche. Some financial services companies can use this to their advantage to generate very high spreads.

Largely the spreads are in the range of 2-2.5 per cent. In some sub-segments though, the spreads are very high and can climb to as high as five per cent or more. But the question is: why is there such high growth? The answer lies in the credit-to-GDP ratio — which is lower than in developed countries. Credit-to-GDP in India is about 70 per cent, whereas in the US and other developed countries it is in excess of 150 per cent.

Today, banks are reaching out more to the under-served and under-penetrated (which were being exploited by moneylenders) and the unbanked. Obviously, the growth rates will continue, and there is little likelihood of a slowdown in this segment.

Given the fact that penetration is low, given the fact that the government is focusing on segments such as agriculture, and given the fact that some corporates are seeing a change in their India fortunes, there is room for credit growth in the consumer space.

Private-sector banks are also milking the retail segment, especially after the arrival of credit bureaus such as CIBIL, which provide ready references regarding the credit-worthiness of individuals. Says Shah: “Private banks are playing to their key strengths. Besides, the best part this time around has been because of retail credit. We are not in the 2009 credit bubble because credit bureaus are driving more growth.”

Six bank stocks make up about 80 per cent of the weighting in the Bank Nifty. These are HDFC Bank, ICICI Bank, Axis Bank, Kotak Mahindra Bank, IndusInd Bank and SBI. Hence, not all banking stocks may be moving the index as much.

The valuations of bank stocks are not now inexpensive. NBFCs are quoting at life-time highs. Private-sector banks are trading at reasonably rich valuations. Public-sector banks appear inexpensive on valuations. On adjusting for their pain and non-performing assets though, their price-to-adjusted book values also makes them appear richly valued.

SBI is trading at 1.5 times adjusted book value, while Bank of Baroda is at 1.4 times, and PNB at 2.2 times for FY18. The PNB stock is trading at near similar valuations to Axis Bank, which has a price-to-book value of 2.4 times. Hence, many stocks may not appear inexpensive from a short-term perspective of about a year. Investors have to hold them for at least more than a year for any meaningful potential.

Some stocks in the micro-finance and rural spaces, while rich in valuations, do provide some comfort in holding for the short and longer run, due to their better growth rates. Ujjivan Financial Services and Equitas Holdings are cases in point. Equitas is trading at 2.2 book today, while Ujjivan is at 2.4 book. On returns on equity, however, they generate considerably higher profitability than public sector banks.

Returns on assets for Ujjivan and Equitas are expected at 2–2.5 per cent, which is steeper than PNB’s 0.5 per cent, suggesting that there is ample scope for upside in the former stock counters. Hence, companies in small finance could be looked at. However, stocks such as Satin Credit have run up considerably; hence, investors have to pick and choose carefully in this segment.

Says Fernandes: “If something is at fair valuations, the potential is restricted. You should buy something that is less expensive than fair valuations. That will then provide you with meaningful potential.”

Ujjivan Financial Services may be a good bet as the company is transitioning from a micro-finance operator to a small finance bank. This helps it increase the size of loans on the asset side. On the liability side, it can raise deposits that a micro-finance cannot. With a larger all-India presence, and government support to the rural and micro side, the stock appears inexpensive.

IndusInd Bank, too, looks good as it is diversifying into cars, two-wheelers, home-loan micro-finance, and loans against shares. Given its investment in branches and people, its retail book growth is expected to be strong. It has a high RoA of 1.9 per cent, and this valuation will persist.

Another bank that makes the cut is DCB Bank as its expansion is unique. It is expanding in the northern states where it has fewer operations. Its focus on profitability and growth should stand it in good stead over the years.

Some public sector bank stocks such as PNB and Canara Bank have run up considerably, and hence should be off the investment radar for now. Returns on assets in some of these banks are low, while at the same time there is huge expectation built into the recovery cycle for these banks.


1 Financial sector stocks are a proxy to the economy and the consumption story through rising retail loans

2 The Indian banking sector is being driven due to a lower credit-to-GDP ratio and rising household loans

3 Overall banks are fairly valued, but there are pockets of a meaningful upside in some fast growing small banks

4 The rural and micro-finance space appears reasonably well-placed given the growth prospects of the segment

5 PSU banks are a tad richly valued especially as a larger expectations have been built-in into the sector on the recovery

6 A few private sector banks have a lot of potential given that the retail loan penetration is just about rising

7 Corporate loans are still in the stress zone and credit off-take has still not taken off due to restructuring of the economy

8 NBFCs are also a fast-growing space thanks to the penetration of retail loans, but valuations are steep

9 Investors need to keep a longer investment horizon of more than a year for meaningful returns from the sector

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