As I can see in your portfolio, you have a clear tilt towards the larger private sector players, as far as banking space is concerned. First of all, I want to talk about the narrative which is building up that credit growth argument is still very strong here in India, but it is actually the NIMs which may come under pressure. Now, the degree may vary among large banks, which bank may come, some banks are shielded in terms of NIM pressures, but what is the kind of range do you see the impact coming in the next four to six quarters as far as the NIMs are concerned?
With respect to margins, over the last four quarters, we have seen a material decline in margins at Indian banks to the extent of 30 to 50 bps depending on the bank we are talking about. I think so the pace of margin decline will moderate meaningfully. Over the next 12 months assuming no rate cut from the RBI, we expect margin decline to be in the range of around 10 basis points. What has happened is that bulk of the term deposit rate hike is now priced in. The term deposit rates are still moving up, which means that deposit costs will continue to rise, not to forget that CASA ratio is also moving lower. But the extent of decline will be manageable. Banks have some wherewithal to shift loan mix towards higher margin assets. And to an extent, there is some normalisation in comparative intensity. So, overall, the margin decline should be to the extent of 10 basis points for the sector.
Within that entire large private sector pack, there is a section of banks which are now trading at trough valuations, perhaps the lowest in decades. Some had some special situation, kind of mergers going on in them. Some had leadership issues. But the fact of the matter is that they have undergone a very long time correction in terms of valuation have come down. But their business in this duration has actually grown. Do you think that the entire brunt of selling which some of these names have seen because FIIs reducing weight, all of that is over, it is troughing out now, and next 12 to 18 months actually look good here in some of these candidates?
That is an interesting point and actually I will highlight one of the analysis that we have done. And when we have looked at banks that come out of a slowdown or recession, what we see is that in the first two-three years the higher quality banks or the banks which were trading at higher valuations and delivering strong earnings, they tend to underperform and the reason for that is very simple.
The banks which have struggled to the asset quality cycle over there the earnings expectations are low, the valuations are depressed and to that extent from a stock market perspective the earnings upgrades as well as valuation re-rating can be quite meaningful and we have seen a lot of stocks double and triple over the last two-three years. If I look at the private banks now and I look at the valuation gap relative to state-owned banks and some of the other low-quality banks, the valuation gap has narrowed quite meaningfully and which is why over the last one year we have been shifting our preference from some of the lower quality private banks or some of the lower quality state-owned banks to large private banks. And we think over the next three years, as you see some of the earnings headwinds play out, you will see the asset quality cycle normalise, you will see margins moderate as competitive intensity remains intense, the large private banks which have invested in technology, which have invested in distribution expansion, they will be able to manage the pressure in a much better way and which is where while the entire sector will do well, they will gain some scarcity premium over the next two-three years.
But one space which was scarce and is no longer is the public sector entities because I am going through your list of recommendations. You have upside of anywhere between 25% to 30% on IndusInd, AU Small Finance Bank, ICICI, Kotak, etc, but when I am looking at a PNB, a Canara Bank, a State Bank, they have a downside perhaps of anywhere between 5% to around 40% depending on the current market price. So, clearly you are saying that the public sector space has become too overheated and it is not the best time to make fresh allocations there?
I do not want to comment on individual stocks, but I will leave you with some broad comments. Some of these stocks have done really-really well over the last two-three years. They have doubled and tripled and I think they will continue to compound because the macro is very benign. I do not see asset quality normalising anytime soon. I think the credit costs will remain benign. They will inch up from very low levels right now, but the asset quality cycle will remain benign.
There will be decent loan growth. So, I think you will see earnings continue to compound across the sector, be it state-owned banks or private banks. But when I look at valuations, which have just not done well for the private over the last three years, the risk reward for them is materially higher and that is how we put out our relative preference that you are talking about.
I want to also talk about some of the names which have very interesting CV tilt and there are certain ideas where there are stated promoter commentary of aim or interest in raising stakes. What are your thoughts on names such as these or even some of the names which have more tilt toward SMEs? Yes, they have done very well in the last few quarters and now kind of sobered down their growth outlook, but do you have a compounding opportunity in these kind of ideas as well?
I think you are talking about some of the mid-sized private banks. So, as a group, the way in which I think about them is over the last three years, they have focused on improving the liability franchise. They have been hurt because a rising rate cycle is negative for some of the mid-sized private banks.
But what is going to happen as liquidity improves, as the rate cycle turns, these banks will be able to hold on to margins much better than some of the other weaker banks. So, from a two-three-year perspective I think so this space is interesting. But I just want to be very clear, within the entire banking space and within the private banking space, we have a tilt towards the larger players rather than the smaller players.
We think the larger players have invested in technology, they have economies of scale, they have improved underwriting practices.
And when I see through cycle, I think they will be doing much better than the mid-sized players. But yes, there are stocks which we like in the mid-sized space as well. As a bucket, we like large players more than small players.
I also wanted to get your sense regarding the latest RBI actions that we have seen. And I am talking about both NBFCs and banking names combined. Is that increased vigil around unsecured lending, they are talking about CDR in a very emphasised manner. Do you think it is something which is warranted or there are some shocks in the system that we should perhaps be prepared for? What is your view on the asset quality and the unsecured end of the book because a couple of those banks are now going back to the corporate lending and moving away from retail?
Our understanding of the RBI measures is that a lot of them are proactive. Our understanding of the asset quality cycle right now is that we are very, very, very fine with the kind of underwriting that is happening and we do not see any asset quality cycle for the system over the next 12 to 18 months.
When I look at retail and SME lending, we generally do not see players go down the quality curve. There will be some pockets where players are compromising, but at the system level, those are not that big.
On the corporate side, we have not seen that much lending. Bulk of the lending is really working capital related and we are yet to see a private corporate capex cycle.
So, I think so on asset quality cycle the credit costs will remain benign. What the RBI is trying to do, as per our understanding, is trying to be proactive and there could be certain pockets where there could be mislending and so on and they are trying to be proactive.
You look at the guidelines that they have put out for projects under implementation and the upfront provisioning requirement. Fundamentally, that is a good move because if you look at infrastructure loans for the first three years, you earn very good income on that.
There is very strong margin. You get a lot of fees and there are no NPLs because the project is under implementation. The NPLs come in the fourth to sixth year because these are long-term loans. Now, if you actually are upfronting some bit of the provisioning, it is actually a good move. I am not saying whether 5% is right or 3% is right, but the ideology and the framework that the RBI is trying to work with is proactive and I think so one is trying to reflect some of the learnings that we should have done based on what we saw in the last corporate loan growth cycle.
What is stopping the FIIs or investors to come back to the private banking names? I mean, the consensus is clearly that they are cheap. The consensus is that there is no problem in the asset quality. Yes, a moderation in NIMs and growth, but that is also largely known and factored in. What then is the big factor which is impeding the comeback of, let us say, FIIs and other investors?
I think investors have been positively surprised with respect to earnings over the last two-three years. Some of the answers could be individual stock specific and that could characterise why some of the investors are taking time, but when I think of the outlook from a two-three-year perspective, there will be a lot of bids from the FIIs. The earnings are going to be very resilient and what is also happening is that there are opportunities outside of the large private sector banks which were very well owned, that have come up now that the economy is doing well.
So, there are multiple factors. But if you will ask me from a large private bank space perspective, they will do well over the next two-three years and will continue to re-rate.
