Bank-able Bets!

Is re-rating on cards for PSU Banks ?

Business of Banking is no fancy business . It inspires boredom at its best or evokes outright yawn at its worst . But the banking stocks are a different story . They are not staid and stale . There is a lot of hustle and bustle around them . Banking is a seductive sector for serious investors . With their heavy-weight status in benchmark indices , they have the power to move the markets. They are proxy to macro and hence extremely pro-cyclical, thus providing “hi-alpha” opportunities to savvy investors at the turn of every cycle .

Let us take the boring part first . Banks are about patching the depositors to borrowers . Core revenues stem from lending ( interest income) to corporate and retail . Treasury income  ( bond portfolio) and advisory-fee income are the add-on revenue streams of banks .  Bad loans ( NPAs – Non Performing Assets) are the inherent part of the business and its management determines the key metrics of profitability etc . So much for the basics . Where the story takes interesting turn is how certain metrics that the market is obsessed with responds to macro reversals  in a pro-cyclical fashion to provide large alpha opportunities for investors.  Pro-cyclicality refers to positive correlation and magnification of closely watched metrics in relation to economic cycles ( macro changes).

Take for example some of the closely tracked numbers for banks – stressed assets ( NPA) , Capital adequacy ( CAR) , restructured assets , bad loans write-offs , income from bond portfolio etc – all these move in a tandem with the economic fortunes or its misfortunes  . Each of these moves in a self-fueling fashion to amplify the underlying trend at every economic cycle , thus creating huge , yet predictable variance in earnings for banks . In a down-cycle , when the economy turns sour , surge in stressed assets leads to large NPAs / Write-offs which in turn leads to tightening of noose by hike in lending rates that in-turn slows business further down leading to more NPAs / stressed assets etc , thus fueling a self-feeding down-ward spiral  . It does not stop there . Larger provisions / write-offs reduces the available capital with the banks ( in the form of reduced CAR) that in turn further slows down lending which fuels the self-feeding loop   further to eventually bring down the closely watched metrics to manically distressed levels .  Opposite occurs in the up-cycle in a similar self-feeding manner – write-offs miraculously turn into write-backs boosting profits that lead to  more cushion in the capital (CAR) which in turns fuels more lending leading to more business momentum and hence more loan recovery ( write-backs) etc – thus setting off an upward spiral in earnings .

In these twist and turns , what makes the plot interesting is how bank’s valuation in terms of its price to book (book value)  responds to this self-feeding saga. Price to book gets pricey in the top of cycle and dives to depressingly low in the bottom of the cycle . The swing in price-to-book can be as high as 3 to 4 times over the life of the whole cycle . Not to forget that the book itself is torn far from fair value  by the gyrations in NPA provisions – boosted by write-backs in up-cycle and depleted by write-offs in the down-turns. Add to this , the organic business growth or de-growth in  the economic cycle that further inflates or deflates the book  .  As a result the variation in the stock price based on price-to-book can be even multiple times over the cycle . For PSU banks it is further magnified because of limited headroom for capital infusion ( given the dire state of govt. finance)  and high exposure to cyclical sectors  . This is precisely  where the biggest alpha opportunities arise for savvy and diligent investors .

The valuation is most attractive ( rather most distressed) when the uncertainty is the maximum i.e. when slippages and stressed assets see the maximum increase . This was the case last year . Now , we are past that stage  with increasing visibility on economic recovery and on interest rate reversal . At this stage , though valuation is not at distressed level , many PSU banks at sub-one time price-to-book ( adjusted for the net NPA) , still offer strong  upside potential over the full rate-easing cycle  . Seen from historic prism   , valuation surges up to two times the book at the top of the cycle in the case of PSU banks , thus providing excellent opportunity to gain from substantial rerating in this space    . Given that the book itself will be growing on treasury gains , write-backs and increased  business momentum etc  , the upside potential can be  far higher  .

There is of course a caveat . Being  a high beta space , PSU banks as a stack exhibit high volatility . While that increases the short-term risk , it can also be used as accumulation or nibbling opportunities for significant long-term gains. Watch out for interesting times in this space.

ArunaGiri . N