Bank Sector Funds:Ready To Rebound?
Leading private sector banks with heavy weightage on indices such as HDFC Bank and Kotak Mahindra Bank have beaten the street expectations as far as the results are concerned. And now with favourable news regarding the opening up of the economy and a decrease in unemployment figures, the banking sector is all set to come out of its depression phase
The year 2020 started on a very good note for the equity market with the frontline and broader indices touching their lifetime and recent highs. Nonetheless, then came the corona virus and everything slowed down to a screeching halt. However, there were some notable exceptions, sector-wise, such as information technology (IT) and pharmaceuticals. After their initial fall these were the first and fastest to recover.
If we look at their returns from January 2020 to September 2020, they were at 26.9 per cent for IT and a whopping 46.3 per cent for the pharmaceutical sector. Nonetheless, all sectors did not perform in a similar way such as banking, finance and public sector undertakings (PSUs) which failed to recoup their losses. Presently, when we are seeing Nifty 50 moving towards its pre-pandemic level, Nifty Bank still has a lot of ground to cover. This is reflected even in the returns provided by the funds dedicated to such sectors.
So, the question is whether the banking sector will witness speedy recovery to become the next IT and pharmaceutical and what should be an investor’s approach towards the funds dedicated to banking stocks? In the following graph we will first understand how the fundamentals are placed for the banking sector and then we will focus on investing in banking funds.
The graph above clearly shows how Nifty Bank witnessed a free fall and even if the Nifty 50 is near its pre-pandemic level, Nifty Bank is still 25 per cent down from its pre-pandemic level. Such a free fall in the banking sector index can be attributed to the expected increase in non-performing asset (NPA) numbers due to a sharp drop in economic activity on account of the pandemic-triggered lockdowns and the rising graph of unemployment. During April 2020 and May 2020, the unemployment rate was 23.52 per cent and 21.73 per cent, respectively. This led the Reserve Bank of India (RBI) to declare moratorium wherein borrowers can opt to defer their equated monthly instalments (EMIs).
Initially the moratorium period was only for three months ending June 2020, which was further extended for the next three months until September 2020. This might become a trigger for a rise in the potential NPAs going ahead as the moratorium was like treating the symptoms and not the disease. Even the RBI’s Financial Stability Report (FSR) that was released in July 2020 showed some signs of stress in banks’ asset quality.
According to the RBI’s FSR, the banking sector is likely to witness a significant rise in bad loans amid pressures of the pandemic and nationwide lockdowns. Its stress test suggests that the gross non-performing asset (GNPA) ratio of all scheduled commercial banks is likely to surge from 8.5 per cent in March 2020 to 12.5 per cent by March 2021 in the baseline scenario. However, if the macroeconomic environment worsens further, the ratio might escalate to 14.7 per cent in a very severe stress scenario. Further, in case of public sector banks, the GNPA ratio of 11.3 per cent as of March 2020 might elevate to 15.2 per cent by March 2021 in the baseline scenario. And in the case of private sector banks and foreign banks, the GNPA ratio may surge from 4.2 per cent and 2.3 per cent in March 2020 to 7.3 per cent and 3.9 per cent, respectively, by March 2021.
The results of the stress test at the bank level indicates that 23 banks with a share of 64.5 per cent in scheduled commercial banks’ total assets might fail to maintain the required capital to risk-weighted assets ratio (CRAR) in the 3 SD (standard deviation) shock to the GNPA ratio scenario. One of those 23 banks already had its CRAR below the RBI’s required level of 9 per cent even before applying the stress test. In such an extreme shock scenario, the CRAR of all the 18 public sector banks is likely to go down to 9 per cent.
Under the scenario of 3 SD shock to the GNPA ratio, CRAR would fall below 7 per cent for as many as 20 banks which would dominate the list of banks witnessing large capital erosion. Further, 15 and 20 banks would record over 6 per cent decline in CRAR under 2 SD and 3 SD shocks, respectively.
The above graph shows the assumptions based on which RBI’s stress test works. The assessment is done under stringent hypothetical adverse economic conditions and hence should not be interpreted as forecasts. However, looking at the current scenario, there are quite a few events taking place which might go in favour of the banking sector. Let us look at them one by one.
End of Moratorium Overhang
As on October 27, 2020, the RBI released a notification stating, “The Government of India has announced a scheme for grant of ex-gratia payment of difference between compound interest and simple interest for six months to borrowers in specified loan accounts (March 1, 2020 to August 31, 2020) on October 23, 2020, which mandates ex-gratia payment to certain categories of borrowers by way of crediting the difference between simple interest and compound interest for the period between March 1, 2020, to August 31, 2020 by respective lending institutions. All lending institutions are advised to be guided by the provisions of the scheme and take necessary action within the stipulated timeline.”
The Ministry of Finance last week also approved guidelines for the scheme for grant of ex-gratia payment of the difference between compound interest and simple interest for six months of loans up to Rs2 crore which is sort of an early festive season gift to borrowers. These guidelines came post the Supreme Court directive to the central government to implement interest waiver on loans of up to `2 crore under the RBI moratorium scheme as soon as possible in view of the ongoing pandemic. The benefit is not just applicable to borrowers who availed the loan moratorium fully or partially but also to those who did not avail it. Those who did not avail of such a loan would be benefitting from the government’s compound interest waiver scheme.
Favourable Employment Rate
Many would argue that even though the abovementioned scheme would waive the interest part in the moratorium period, it doesn’t guarantee low NPAs. As is known, the moratorium itself was a product of rising unemployment amid pandemic. However, the unemployment rate has drastically reduced from 23.52 per cent in April 2020 to 6.67 per cent in September 2020. This indicates signs of things heading towards normalisation. Not just that but many companies have also started rolling back salaries to the pre-pandemic levels. This would ensure timely honouring of their EMIs so that the NPAs will not shoot up as has been expected.
Better Quarterly Earnings
All the above factors are reflected in the recent quarterly results. Leading private sector banks with heavy weightage on indices such as HDFC Bank and Kotak Mahindra Bank have beaten the street expectations as far as the results are concerned. HDFC Bank has the highest weightage of 26.68 per cent and Kotak Mahindra Bank has a weightage of 16.66 per cent in the Nifty Bank index. Hence, this quarterly earnings’ season seems to be going well for most banks. Even the NPAs are lower on a sequential basis.
Attractive Valuation
In terms of valuation, the Nifty Bank index has fallen quite a bit from the earlier elevated levels. Usually, banks are valued-based on the price-to-book value (P/B) rather than price-to-equity (P/E). But here we would be looking at both the valuation metrics. In order to analyse the valuation, we have taken P/B as well as P/E of the Nifty Bank index from October 2000 to September 2020.
If we look at both the valuation metrics, they are of-lows. In fact, both P/B and P/E are close to their long-term average. P/B is below its 20-year mean and P/E is marginally above its 20-year mean. This shows that the valuation of the banking sector is at the lower end and does seem attractive.
Benefit from Sector Rotation
The term sector rotation is nothing but an act of switching investments from one sector of the economy to another. This strategy is used as a way to capture returns from market cycles and to diversify holdings over a specified investment horizon. According to a report from CLSA, empirical data from the past 10 years shows a tendency of 60 per cent of the performance leaders of the first nine months becoming underperformers in the last quarter of the calendar year and laggards turning into outperformers. This leads to shift the focus from IT and pharmaceuticals to banking, cement, infrastructure, etc. as economic normalisation is likely to favour domestic plays.
The good news is that there has been a 20 per cent decline in India’s active coronavirus cases from its peak and hopes of a vaccine in the year 2021 may drive economic normalisation over the coming months. Data from the past few years depicts an interesting trend in the change in performance of leaders and laggards of the quarters of January to September and October to December. Over the past five years, a median of 60 per cent of the top 10 best outperforming large-cap stocks of the first nine months of the year (January to September) have ended up underperforming the benchmark in the last quarter, i.e. the October to December quarter.
The corollary of this also seems to be true as the last five years have seen a median of 60 per cent of the 10 most underperforming stocks of the January to September period outperforming the benchmark in the October to December quarter. Perhaps this is evidence of investors booking profits and repositioning their portfolios for the next calendar year. Therefore, banking and financials along with cement could be gainers as investors reposition their portfolios to match the normalisation of the economy in the upcoming calendar year 2021.
The above two graphs show the top 12 stocks that outperformed and the top 12 stocks that underperformed Nifty 50 during January 2020 to September 2020. From the graphs it is clear that during this period, mostly IT, pharmaceuticals and Reliance Industries performed well, whereas banks and financials underperformed. Therefore, as per the sector rotation analogy, it is quite likely that investors would start booking profits in IT and pharmaceuticals to restructure their portfolio by investing in banking and financials.
Investing in the Banking Sector
There are basically two effective ways to invest in the banking sector – either invest in active banking funds or in the banking index by investing in banking index funds or exchange traded funds (ETFs). To decide which way to go we need to understand constituents of actively managed banking funds and the banking index.
The above two tables clearly show that both actively managed banking funds and Nifty Bank index have similar holdings with near about similar weights. Therefore, it makes more sense to invest in index funds or ETFs rather than in actively managed banking funds as the constituents are more or less the same and the expense ratio of index funds and ETFs would be quite less as compared to actively managed funds. Below is the list of the top 10 banking ETFs and index funds ranked on their expense ratios. Funds with lower expense ratio get higher ranking.
As can be seen from the above table, the expense ratio of ETFs and index funds is quite less than that of actively managed banking funds which stands around 2.51 per cent on an average for regular plans and for direct plans it won’t be less than 1 per cent. Hence, it makes a lot of sense to opt for ETFs.
Investment Strategy
Events such as decreasing number of virus cases, economic activity getting back to normal, reducing unemployment rate and roll-back of salaries are favouring the banks. However, a word of caution for investors: the second wave of corona virus has been recorded in Europe and the US. Hence, there is a lot more possibility that it may hit India. Or, perhaps, it may not. Since we are part of the global market, we may get impacted by the performance of what happens across the world. Moreover, as the vaccine is expected by FY21, investors should be cautious regarding the second wave of corona virus which might again disrupt operations. Therefore, do not invest in banking funds or ETFs at one go. Rather it would be prudent to invest in a staggered manner.