Financials attractive after market decline, but warrant caution

While the broader indices peaked on October 19, 2021., bank stocks joined the rally about a week later - on October 25. But since its peak, foreign investors have pulled out over ₹1 billion from the banking space. Growing global uncertainties, which could affect growth even domestically, and demanding valuations have been  working against the sector.

Consequently, the Nifty Bank index has declined by 16 per cent from its October 25 peak (41,192 points), with stocks such as IndusInd Bank and RBL Bank correcting by 20–35 per cent. So, what has fundamentally changed?

In the last three years, bank stocks have been among the first to lead a comeback in a broader market. Much of it was on the hope that if there is a widespread economic revival, banks would be the biggest beneficiaries. As January to March each year is a period of robust growth, management commentaries also tend to be optimistic and by April, bank stocks take centre stage.

Whether in 2019 or 2020, this trend played out till September each year, post which concerns around asset quality resurfaced. Banks gradually lost flavour among investors.

In 2021, what accentuated the pressure was the FII selling which increased from September 2021. Valuations of bank stocks shooting up disproportionally when compared with earning potential made the sector vulnerable to FII selling.

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From September 2020 to September 2021, earnings of banks (led by an increase in other income, mainly treasury gains) rose by 25–30 per cent year-on-year . The underlying loan growth for the sector was less than 10 per cent and the net interest income (or core income) grew by less than 8 per cent year-on-year.

Trailing 12-months valuations, meanwhile, had almost doubled during this period, with the average for private banks moving up to 2.4x from 1.3x a year-ago. Leading banks such as HDFC Bank, ICICI Bank, Axis Bank and Kotak Mahindra Bank had restructured 1.5 to 1.75 per cent of their total books and much of the stress came from the retail space. For public sector banks the share of restructured book was over 2.5 per cent. Therefore, even if banks were well-prepared in terms of provision coverage to face the potential asset quality concerns, investors weren’t comfortable with the overall outlook.

Till early February this year, domestic investors, to an extent, were able to compensate for foreign investor selling in the banking space. But they too seem to have taken the sideline  and have been booking profits at every opportunity, for the same reasons cited by FIIs.

Post the recent correction, forward multiples for the sector seem to have cooled off. One-year forward (CY23 ) price-to-book of Nifty Bank index is pegged at a seven-year low of 2.07x. Leaders such as HDFC Bank, ICICI Bank, Axis Bank and Kotak Mahindra Bank have corrected by 15–20 per cent from their October 2021 peaks and appear attractive from a long-term horizon. However, the upcoming March quarter results and management commentary will play a decisive role in gauging the road ahead for the sector, as banks have refrained from handing out positive outlook for two quarters now.

NBFCs and insurers

In FY22, growth for NBFCs (loan growth) and life insurance companies (premiums) has cooled off from FY19-21 levels. NBFCs have had a tough time matching banks on interest rates. Consequently, in pockets such as housing finance, mortgages and personal/vehicle loans, average loan growth of NBFCs was sub-10 per cent while banks managed 10–12 per cent growth in FY21-22. For life insurers, after the initial spurt of demand for protection plans post Covid in June–September 2020, demand fizzled out. Much of the premium growth has been bolstered by long-term savings products. Here too, growth has come off from the 30–35 per cent mark seen till FY20 which has resulted in a near 30 per cent correction in listed stocks in this space from their 2021 peaks.

Key risks

Banks could be vulnerable to earnings pressure with rising bond yields

Insurers face the problem of passing through higher reinsurance costs

Growth may remain patchy for NBFCs

As for stocks, within NBFCs, Bajaj Finance has held up its valuations primarily owing to its near-monopoly status, while even giants such as HDFC Limited haven’t been spared by the market rout. Within the life insurance basket, SBI Life, owing to its ability to fine-tune its portfolio mix between protection and savings, finds preference among investors.