Are Indian banks overvalued?

Last week, global investment bank Morgan Stanley raised concerns over the valuation of Indian bank shares. The investment bank pruned its weight as it didn’t feel justified to have one-third of its portfolio in bank shares, given that most of them have risen by 30% in the last six months.

Indeed, most bank shares have risen sharply despite unflattering results in the first quarter of 2016-17. Some of them have galloped more than 15% since June despite disastrous results. Some like Canara Bank, Punjab National Bank, Oriental Bank of Commerce and Indian Bank have trounced the sector indices in terms of gains. Most of these lenders made losses and reported a worsening of their asset quality.

One explanation for this run-up in stocks could be that public sector lenders are trading at earnings multiples lower than historic averages. Most have a price-to-book (P-B) value of less than one, making them look ripe for buying.

But the similarity ends here for the sector as a whole. If the December and the March quarter results of Indian banks showed public sector lenders as the weaklings and private sector banks as winners, the June quarter numbers separated the sector into three clusters—the weak, the still vulnerable and the winners. And these clusters are ownership agnostic.

Private sector lenders such as ICICI Bank, Axis Bank and Yes Bank are still vulnerable given their corporate loan-heavy portfolio and could continue to face headwinds on the bad loan front, and their P-B values reflect this.

Some public sector lenders qualify as weak as depleting capital, quarterly losses and worsening bad loan ratios could do them in.

Retail focused lenders such as HDFC Bank and even others such as IndusInd Bank and Kotak Mahindra Bank do emerge as winners in the last round of results. However, HDFC Bank, IndusInd Bank and Kotak Mahindra Bank are trading at P-B values of more than four times their FY16 earnings, which some analysts perceive are a tad pricey. Morgan Stanley slashed its weightage on these banks too.

Morgan Stanley’s worries seem to be shared by Credit Suisse too. In a 19 September note, the investment bank said it expects that stressed loans worth Rs3.3 trillion are yet to be recognized by banks as either bad or restructured. This could mean depressed profits and rise in provisioning for another quarter.

As banks announce their second quarter results in October, investors would know whether their patience would be rewarded in the case of public sector lenders and whether private sector lenders would deliver stellar results once more, justifying valuations.