Private Banks: An Attractive Opportunity

Now that we have the exit poll results, it looks like all the stars are aligning for a multi-year structural bull rally in the Indian stock market. Everyone’s buzzing about hot themes like defence, power, PSU, infrastructure, and railways, which are expected to benefit from government spending and favorable policies. But let’s talk about something that’s not getting enough attention: valuations.

Most of these hot sectors have already seen significant rallies, leaving very little room for valuation comfort. They might continue their upward trajectory, but that would require consistent EPS (Earnings Per Share) growth. If the valuation expansion isn’t backed by earnings growth, it could create a trap for investors. So, be cautious with these hot themes. Sure, it’s okay to invest some money in these high-risk, high-reward sectors, but as a long-term investor, we are more interested in stocks that offer value.

One sector that’s currently overlooked and seems very attractive to me is private banks, including small finance banks. Over the last year, while the Nifty has jumped around 25%, the private bank index is up only 10%. The primary reason for this underperformance is FIIs (Foreign Institutional Investors) selling off. Private banks are the most favored sector of FIIs, and over the past few years, they’ve been on a massive selling spree. I found that FIIs have sold investments worth 5.65 lakh crore rupees over the last three years, and a big chunk of that was in private Indian banks. This massive outflow is a key reason why private banks have underperformed.

But let’s look at the quarterly performance of private banks it is been decent. Due to decent EPS expansion and correction or consolidation in share prices, the valuations of Indian private banks are looking attractive, including small finance banks. One reason for the FII selling was concerns over the election outcome. But now, with exit polls indicating a third term for the BJP, FIIs are likely to return to India. They can’t ignore it. Yes, we can debate the premium valuation of the Indian stock market, but the fact is, that India is the fastest-growing economy in the world and shows a lot of potential over the next few decades. So, the Indian market will command a premium.

Now that there is a clear indication of a stable government, the reforms started in the first and second terms would likely continue, maintaining the momentum in the third term. This makes private banks well-placed to benefit from renewed FII investment in the Indian market. The good news is that many of these private banks are available at reasonable valuations.

Here’s a closer look at the current valuation of private banks and FII stakes in each bank. For instance, HDFC Bank has a 47.8% FII stake, ICICI Bank has 44%, Axis Bank has the highest at 53.8%, and Kotak Mahindra Bank has 37.9%. Even mid-tier banks have a decent amount of FII holding, and small finance banks like AU Small Finance Bank and Equitas have significant FII stakes. This clearly shows that FIIs have a strong inclination towards Indian private banks. When FIIs return to the Indian market, they will likely increase their allocation in private banks.

One thing to note is the low promoter holding in these banks. SEBI has a norm that private banks can’t have more than a 26% promoter holding after a certain period. This is why Kotak Mahindra Bank has the highest promoter holding at 25.9%, and others like HDFC Bank, ICICI Bank, and Axis Bank have much lower or even zero promoter stakes. But as long as a bank has high FII and DII (Domestic Institutional Investors) holding with lower public holding, it shouldn’t be a concern.

Let’s also discuss asset quality. Here we have compiled the latest Q4 net NPA (Non-Performing Assets) data for private banks and small finance banks. Except for Karnataka Bank and South Indian Bank, all private banks have NPAs below 1%, indicating excellent asset quality. Even small finance banks have impressive asset quality, with AU Small Finance Bank, Equitas, Ujjivan, and Utkarsh showing very low NPAs.

Profitability, measured via Return on Equity (ROE), is also looking good. Axis Bank has the highest ROE at 20.87%, while mid-tier banks have lower ROEs. Small finance banks also have decent ROEs, with Ujjivan and Utkarsh standing out due to their high exposure to microfinance loans, a more profitable but riskier segment.

Now, let’s talk about EPS growth. We have analysed the earnings growth of these banks over the last year. HDFC Bank is pretty flat due to its merger with HDFC Limited, making year-on-year EPS comparisons tricky. But ICICI Bank has shown a solid 29.3% growth, Axis Bank an impressive 143% (partly due to its acquisition of Citibank), and Kotak Mahindra Bank at 22%. Yes Bank has a remarkable 73% EPS growth, while IDFC First Bank is on the lower side at 10.9%. Federal Bank, Karur Vysya Bank, and RBL Bank are also showing strong EPS growth.

Considering the valuations, all except Yes Bank have P/E ratios below 20. Top banks like HDFC and ICICI have P/Es around 17-18, with Axis Bank at just 14 and Kotak Mahindra Bank at 18. Mid-tier banks like Federal Bank, Karur Vysya Bank, and RBL Bank have even lower P/Es, indicating valuation comfort.

When we look at the Price-to-book (P/B) ratio, it provides a clearer picture. HDFC Bank’s current P/B is 2.8, down from its peak of 5.8. Similarly, Kotak Mahindra Bank is down nearly 50% from its peak valuation. This significant correction from peak valuations offers good valuation comfort.

Even in terms of share price performance over the last year, there hasn’t been much return for many of these banks. For instance, HDFC Bank is down 2%, ICICI Bank has given a decent 22.5% return, Axis Bank 29%, but Kotak Mahindra Bank is down 11%. Yet, banks like Karur Vysya Bank and RBL Bank have performed well, showing 83% and 51% returns, respectively, with promising valuations and EPS growth.

Overall, the earning growth and valuation comfort in private banks, including small finance banks, look promising. While sectors like defence, power, infrastructure, and PSU are likely to continue their outperformance due to government focus, their high valuations require sustained EPS growth to justify. On the other hand, private banks already offer reasonable valuations, making them a solid investment choice if the economy does well.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.