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Business News/ Money / Personal-finance/  Why financial stocks cannot be ignored 
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Why financial stocks cannot be ignored 

Along with the structural long-term growth opportunity for banks, a cyclical turn will also lend positively to stocks of banks and other financial companies

Don't broad brush the sector, some stocks are better placed to benefit in the current cycle; Photo: iStockPremium
Don't broad brush the sector, some stocks are better placed to benefit in the current cycle; Photo: iStock

The financial services sector accounts for almost 35% of the Nifty50 weightage and nearly 34% of the S&P BSE Sensex. Similarly, financial services are the top-weight sector at 27% in NSE Midcap 150 and 24% in S&P BSE MidCap indices. While quite a few banking stocks had delivered double-digit returns last year, there are also a handful of public sector (PSU) banking stocks that delivered triple-digit returns, and financial services sector stocks that have more than doubled. Clearly these stocks can’t be ignored. 

Although some of the negative sentiment in the sector remains thanks to non-performing assets, recovery of dues and provisioning requirements, distinctions among individual companies is becoming sharper. Given the expectation of the bad loan cycle turning, this is a good time to evaluate individual banking and finance stocks. Moreover, there is a secular trend towards financial inclusion and growth in retail assets. This impacts banks, non-banking financial services (NBFCs) and housing finance companies. Here is how you can evaluate these opportunities. 

After reaching a peak of 8% in 2014, domestic repo rate has fallen to 6.25%. Experts forecast another 0.25-0.50% cut, given the macroeconomic environment now. The downward interest rate cycle could be near its end after that.

Over the next 2 years, if economic growth picks up, the interest rate cycle could start to turn. This will impact bank and NBFC lending rates. Higher lending rates can happen quickly, but savings deposit rates don’t change that fast, potentially raising the net margins and leading to higher profitability. 

According to Nikhil Johri, founder and chief investment officer, Trivantage Capital, “Banks with a higher proportion of retail deposits will benefit when rates move up. One also has to consider the incremental growth in savings deposits and not just the existing balances." 

The complete benefit for banks with a strong liability (deposit) base will be visible only after the lending activity improves, which might take up to 2 years or more. Nevertheless, if identified before the turn of the cycle, such opportunities have the potential to deliver above-average returns. 

When financial health of a bank improves, be it through growth or restructuring of bad assets, both the debt and equity markets begin to reprice its securities. Johri says, “Understanding the inter-linkages between the credit (debt) and the equity markets in case of banking and NBFC stocks helps in identifying any market mis-pricing and taking advantage of it." 

Citing an example, Johri explained that Indian Bank’s stand-alone credit profile (without sovereign support) was quite strong as compared with equity valuation of less than 0.5 times price-to-book value. The question was: whether it’s bond market credit perception was more accurate than it’s valuation in the stock market. “This belief led us to take advantage of the mis-pricing in the bank’s stock," said Johri.

In the last 1 year, its stock has more than doubled from a price of around Rs140 to Rs310.

Such cyclical opportunities do not apply to all stocks, and need to be analysed individually keeping in mind the management and its ability to execute opportunities. Also, in the near 1-3-year period there are several factors like macroeconomic factors, interest rate cycles and economic growth, which can impact the financials of individual stocks in this sector.

Gopal Agrawal, chief investment officer, equities, Tata Asset Management Co. Ltd, said, “If the stress on asset quality is under control in individual banks, the relative position will look better. The entire sector can’t be painted with the same brush—one has to look at factors like capital structure and provisioning." 

These are not long-term buy and hold strategies, rather more cyclical in nature and tend to play out over 3-5 years or sooner. 

Corporate banking and non-performing assets have been problem areas, but here as well with asset reconstruction companies stepping in, the regulator pushing banks on provisioning and identifying specific accounts for insolvency proceedings, there is hope for limited recovery of dues. Most of the loans from capital-intensive sectors have physical assets or plant and machinery as collateral; experts don’t consider these as write-offs given the potential to realise value once utilization rates improve and cash flows revive. 

At the same time, retail banking is still strong. According to Agrawal, “Formal lending in India is likely to improve and post-demonitization there is an increased scope of bringing more people within organized banking and financial services." 

Along with adding new accounts, retail banking is also on a stronger ground because existing account holders rarely shift out. Rather, they increase banks’ balances consistently over the years. Older banks with large retail deposits therefore stand to benefit. According to a senior fund manager, “Even for the weakest PSU bank, savings account deposit balance grows at around 10-12% per annum." 

Another opportunity lies in newer markets opening up for financial products. According to Sunil Sharma, chief investment officer, Sanctum Wealth Management Pvt. Ltd, “If you look at certain themes in the space, it’s the scaling up of financial services that is encouraging. Insurance penetration (including general insurance) in the country has a great opportunity to scale up. There is a sustainable opportunity in the capital markets space. For example, brokerages and distribution companies are gaining, thanks to regular mutual fund flows from tier 2 and tier 3 cities." 

The equity market has already recognized some of this opportunity as a few of the brokerage, housing finance and financial services stocks have rallied 100-200% in the last 1 year. While the opportunity to grow will remain, buying these stocks now will depend on whether you think stocks are reasonably priced or still have room for upside. 

Both cyclical and secular opportunities exist. Keep in mind though that cyclical opportunities are high-risk and high-reward. If mistakes are made in identifying the right stock, then the downside could also be steep. 

The opportunities will be sector-wide, but you must support your choices with the basics of individual companies’ financial health, management quality and ability to execute. If this is sounding too much to follow through, take the help of managed portfolios like mutual funds or a portfolio management service you can trust.

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Published: 28 Jun 2017, 04:36 PM IST
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