Why private sector banks have huge valuations

Asset quality problems of Indian banks has been a much discussed topic over the past few years. Ignored but probably the more relevant focus area for investors is likely to be the other side of the balance sheet, i.e. liabilities.

Depositors and equity investors - two main contributors for banks’ liabilities, are exhibiting behavioural patterns, which are quite interesting and have much relevance for investors.

Market share of public banks in deposits has remained high at 75% of the system since over a decade and has barely changed. This is despite the well-recognised problem of asset quality for these banks in the past few years.

In a ‘rational’ world, an individual depositor would have looked to move out of some of these banks given the concerns of asset quality and capital adequacy levels. Factors like the sovereign backing of the government (as majority owner of these banks), decades of physical presence in the neighborhood, etc., have meant that depositors continue to remain with these banks. This provides much needed time for these banks to generate pre-provisioning profits to write-off the unsustainable debt that they have extended in the past, improve their operations and eventually be able to service the claims of depositors.

Thus, the collective behaviour of the group of depositors makes this apparently ‘irrational’ decision of an individual of not taking out funds from a ‘weak’ bank self-fulfilling and ensures a satisfactory outcome for all depositors.

Market capitalisation of private banks has seen a steady growth over the past decade, ratio of market capitalisation of top-six public banks to market capitalisation of top-six private banks which was 1.1X in FY05 has reduced to 0.4X currently.

Implying that the investors expect the private banks to improve their market share and maintain their profitability. The track record of profitability has been impressive for these banks and is reflected in the proportion of pre-provisioning profits increasing to 31% of overall banking industry pre-provisioning profits in FY16 compared to a mere 11% in FY05 and further their reported asset quality is quite healthy.

Another factor that has aided this stellar growth in market capitalisation for the private banks is the collective investor behavior (and this requires explanation). Banking being a highly capital-intensive sector requires constant infusion of equity capital. This is reflected in the high proportion of shareholder premium account-to-overall reserves of these entities (in excess of 50% in many instances). In a ‘rational’ world individual investor will not be willing to pay a high price-to-book ratio (PBR) for an entity with high levels of shareholder premium-to-overall reserves. However, if she/he is convinced that future equity infusions will continue to happen at PBR, this apparently ‘irrational’ decision becomes perfectly justified and attains a self-fulfilling character. Richly-valued banks provide the managements with a valuable strategic asset—stocks as a currency to undertake inorganic initiatives and acquire complementary businesses. The success of such endeavours would depend on the availability of an appropriate financial entity, price of acquisition, speedy integration of these businesses, etc.

Thus, both sets of liability holders of banks—depositors and equity owners, are displaying behaviour which is ‘irrational’ at an individual level but because of collective action, these actions become perfectly justified and attain a self-fulfilling character. An appreciation of this dynamic may be critical for investment decisions.

An equity investor (based on this analytic construct) has two broad choices at the current juncture.

First, investors can buy into low PBR bank stocks currently and expect - a return to normalised earnings over the next few years; an improvement in operations as banks chastened by this asset quality experience undertake corrective measures and no meaningful dilution in shareholder base in the interim as capitalisation levels are adequate. Second, investors can buy into high PBR stocks with the expectation that - trend of the past five years will sustain; managements of banks with high valuation will leverage their stock price judiciously and successfully undertake inorganic acquisitions given the high absolute levels of market capitalisation.

The writer is fund manager – equity at LIC Mutual Fund