At present, bank stocks can be clearly demarcated into various cohorts depending on size, ownership and asset quality. The banks in each of these cohorts are trading at very different P/B multiples. The market sentiment in recent months has been largely negative towards corporate focused private lenders and PSU banks owing to the increase in gross NPLs and decrease in profits which is a result of higher provision on bad loans.
That said it is important to note, that the banks do generate certain level of Pre-Provisioning Operating Profit (PPOP), which can be used to absorb the provisioning requirements, in addition to the available capital. This PPOP, in case of certain banks, can very easily absorb the further provisioning that will be required to be done in order to be compliant with the regulatory norms.
As a result of the Asset Quality Review (AQR) which was conducted by RBI, in my view, a large part of the stress has already been recognized by the banks. The low gross NPL formation along with potential recoveries could see the stock of gross NPLs for the banks reduce from here on. The reduction in gross NPLs will reduce the provisioning required thereon thereby providing a fillip to the banks’ earnings and the stock.
Investment strategy for current market situation:
We should continue to follow fundamental driven bottom up approach for picking stocks. This process enables us to typically focus on the fundamentals of the business with the earnings and cash flow generating capability of the business being at the forefront of our analysis. An important factor favoring the investors is that risk averseness is quite high among corporate, banking sector officials and investor community given the experience of the past 8 years (since the great financial crisis of 2008). This significantly reduces the probability of permanent loss of capital, though there could be heightened gyrations in stock markets (as witnessed in FY16). These factors are likely to help deliver healthy returns for investors over the medium term on a tax-adjusted basis. Investors are advised to use the corrections to buy into equities and create wealth for themselves over the medium term.
The author of this article is Mr. Saravana Kumar, CIO, LIC Mutual Fund.