In banking, use Graham’s weighing machine rule to pick the best stocks

The views and opinions expressed are of Mr. Arun Thukral, MD & CEO, Axis Securities.

India’s banking sector has evolved over the past two decades, transitioning from simple automation of paperwork in bank branches to today’s branchless banking paradigm. It supports one of the world’s fastest-growing economies, but is grappling with challenges that are testing its strength and resilience.

Primary among them is the burden of distressed loans and liquidity issues. Unlike the past, however, the focus is not just on recapitalisation of banks but on greater structural changes through recognition and faster resolution for non-performing assets.

The NPA situation is showing signs of stabilisation in the last one year, with the bulk of legacy NPAs already recognised. According to RBI’s latest Financial Stability Report, GNPA ratio may decline from 9.3 per cent in March 2019 to 9 per cent in March 2020, from a high of 11.5 per cent in March 2018.

The proposed Rs 70,000 crore capital infusion into public sector banks, announced in the Budget, will help PSBs make necessary haircuts on weak corporate loans and shore up capital adequacy. PSBs still require substantial reforms to improve risk management, efficiency and diversity in product offerings.

The liquidity crisis in NBFCs, HFCs, blown up by the likes of IL&FS and DHFL has ensured greater market discipline with these segments as better-performing companies continued to raise funds while those with ALM and/or asset quality concerns were subjected to higher borrowing costs.

Recognising that NBFCs play an important role in sustaining consumption demand as well as capital formation, the most important Budget measure announced was the provision to create a Rs 1 lakh crore securitisation facility with a government guarantee. While this guarantee won’t help clean up the entire NBFC mess, it will provide immediate relief to the sector by restoring confidence among NBFCs.

The Budget proposals may help NBFCs to sell their highly-rated retail pool of assets and address immediate liquidity needs and correct asset-liability mismatches. However, the asset-quality stress emanating from their wholesale real estate-related portfolio will take time to get mitigated.

In the near term, for the private banking space, competition landscape has become better. NBFCs have become weaker and PSU banks are still not out of the woods. The asset quality woes are behind for large private sector banks. They are comfortable on the capital front and this has helped the run-up in banking stocks. Even if credit growth remains lower, large private banks will take an incrementally higher market share due to weak competition.

When the economy does well, banks tend to be one of the biggest beneficiaries due to the demand for credit as market conditions turn suitable for growing loan books. It may be volatile, but the sector will remain positive in the coming years.

Irrespective of whether investment or consumption does well in the future, the banking sector will stand to gain. In the short term, stock performance is determined by emotions and opinions of market participants. However, in the long term, price is driven by the actual earnings performance of a business.

To quote Benjamin Graham, the great value investor, “In the short term, the market is like a voting machine, but in the long term, it is like a weighing machine.”

Investors will do well to focus on operationally-sound banks/NBFCs with good corporate governance and stable management well versed in managing risk.

Originally published in ET Market Moguls, July,19.