Are HDFC Bank, Axis, Kotak a value buy or value trap for investors?

HDFC Bank, India’s largest private-sector financier, has massively underperformed the Nifty 50 over the past year. Its shares rose just 8% in the past year as against the benchmark indices, which were up 27%. The last week has been particularly brutal as the stock corrected from a 52-week high of ₹1,794 and ended down 9.5% and settled at ₹1,623 on October 7.However, out of 41 analysts tracking the stock, 33 have a ‘buy’ rating, according to data from Trendlyne. Shares of other major private banks such as Kotak Mahindra (up 3%) and Axis Bank (up 15%) have also underperformed. HDFC Bank, Kotak Mahindra, Axis Bank and ICICI Bank (up 31%) make up for 80% of Nifty Private Bank Index’s weightage.“There is no doubt, news flow (about private sector banks) is adverse, but only when the news flow is adverse that you get the entry point of cheaper valuation,” says Vetri Subramaniam, chief investment officer at UTI Asset Management.Between 2015 and 2019, there had been a huge divergence within private banks, where HDFC Bank was the poster boy for RoE (return on equity), trading at average 3.3x one-year forward book. Both HDFC Bank and Kotak Mahindra traded at a premium to ICICI Bank and Axis. Now, the tables have turned, where ICICI Bank is trading at an all-time high multiple, whereas HDFC Bank is at the lowest. This has led to an argument within the investor community over ICICI Bank’s valuation.Dhaval Gada, vice president - investments at DSP Asset Managers, said their argument is that if ICICI Bank is replicating the success of HDFC Bank, then why should it not trade at a multiple which HDFC Bank used to trade at those days (average 3.3x)? Today, ICICI Bank is at 2.5-2.6x one-year forward.“My view is that the bank will have to deliver consistently for a few more quarters for investors to realise that it is a teen compounding idea,” he said.According to Gada, the 2004-13 credit boom period was supported by a reduction in reserve ratios (statutory liquidity ratio and cash reserve ratio). “Today, banks are chasing deposit growth to fund credit growth. Till the time RBI softens stances on CD (credit-deposit) ratio and cut reserve ratios, the pressure on deposit may not ease,” he said. medium nocaptionhttp://youtu.be/5zZpHVAoUTk?si=BnvfP4vk6ge8i4UQPrivate vs public lendersFor the longest period, fund managers believed that private banks would eventually capture the entire market share from public-sector banks (PSBs). But over the past five years, there has been a paradigm shift as PSBs became competitive and started to gain both in terms of profitability as well as protected their market share. This sudden improvement has led to higher share prices. On the other hand, private banks remained laggards despite growing and operating under a favourable credit environment.The issue of slower deposit growth particularly made investors wary of private lenders. These banks have been aggressive on growth despite slower deposit growth, which led to a spike in the CD ratio, a key barometer for banks. In addition, many large private banks are facing specific issues like the merger overhang of HDFC Bank and management change at Kotak.Return on asset (RoA) of PSBs grew 56 basis points (bps) to 1.05% in the past two years ending June. As a result, many stocks have been re-rated higher. On the other hand, RoAs of private banks improved just 31bps to 1.89%.But a section of the market believes that the tables are turning, and this could lead to a shift from PSBs to private banks, especially the larger ones.“If you look at what’s happening in the banking sector, the market share of private banks, on an aggregate basis, is about 35% of deposit and about 40% of the loans. But if you look at incremental market share, they are significantly higher than their stock market share. They (private banks) are managing to grow much faster than the rest of the industry,” said Subramaniam.Last month, his fund house launched UTI Nifty Private Bank Index Fund to give investors an opportunity to invest in private banks that are currently under stress.The working thesis is that while the long-term growth prospects of the banking sector remain intact, there are near-term challenges over slowing credit growth, pressure on NIM (net interest margin) and normalisation of credit costs. This warrants a shift to private banks, especially because valuations are attractive. But is this a value bet or a value trap? medium114073425 medium114073433Slowing growthAccording to analysts, the long-term RoE of private banks has come down to around 15-16% in the past 10 years. During this time, the RoE was supported by strong growth, which in turn led to expensive valuations.Now, loan growth is expected to slow down further because of lower deposit growth and as banks are slowing unsecured lending such as personal loans. Rating agency Crisil expects credit growth in the banking sector to slow to around 14% in FY25 from 16% last year.Over the past few quarters, deposit growth has lagged credit growth, leading to a spike in the so-called CD ratio. Even RBI governor Shaktikanta Das told banks to find ways to bridge this gap.This comes at a time when Indian savers are increasingly moving towards capital markets and mutual funds in want of higher returns.As banks are struggling to garner deposits, they are trying to entice savers with higher rates. This has led to a rise in the cost of deposits, which in turn has put pressure on margins. Meanwhile, to control the CD ratio, banks are slowing down on loan growth.“Banks are likely to walk the tightrope between growing their deposit base and shielding their profitability, riding on their ability to mobilise cost-effective deposits,” Crisil said.In a relief to banking investors, provisional numbers for the second quarter showed that banks, including HDFC Bank and YES Bank, reported deposit growth that was higher than loan growth.Another challenge banks are facing is on NIM. They are unable to make up for the NIM pressure through high-margin unsecured lending given the regulatory glare. Early signs of defaults in unsecured loans given by NBFCs and fintechs has made banks cautious.“Regulations will ensure that the RoE of the Indian financial system will not be more than 15-16%. At these levels, you can expect 2-2.5x P/B (price-to-book ratio) but can it get back to 4x, I doubt,” said Rohit Agarwal, senior executive vice-president - investments, Kotak Mahindra Life Insurance.He explained that every five years, the Indian banking system will be de-rated by 5%. Drawing a parallel with large global banks, he said that they trade at 1-1.5x at best.Twenty years ago, some of the private banks were trading at 5-7x because they were growing at 40-50%. With slowing growth, the multiples became 5x and then 4x. “Now, the best in class does not even get 3x. In the last 10 years, one of the leading private bank’s RoE has gone down from 20-21% to 16%, so why should I give it 4x P/B?” he said. medium nocaptionhttp://youtu.be/eB1pBo4WGmA?si=31medAomQELuABO-RBI rate cutInterest rate cut by the US Federal Reserve has led to hopes of a similar action by the RBI. The RBI is expected to keep interest rate on hold at its meeting this week but may reverse the monetary policy stance to neutral. The rate-cutting cycle is expected to start from December, according to bankers.The rate cut is expected to impact private banks’ NIM more compared to public sector banks. But a change in policy stance will boost deposit growth as it implies that the RBI would tolerate surplus liquidity for a prolonged period.Nomura’s analysis showed that a potential 50bps cut in repo rate is likely to reduce the NIM of large private banks by 15-20bps with 5-10bps reduction in RoA because 50-60% of their loans are directly linked to repo rate or another external benchmark.The impact for large PSBs such as SBI and Bank of Baroda is expected to see lesser impact on NIM and RoA. However, they can mitigate the impact on profitability from treasury gains in their bond portfolios.According to brokerage Emkay, the slump in deposit growth is entirely due to system liquidity as it tracks M3 growth very closely. “We believe that deposit growth will bounce back as soon as the RBI reverses its stance, leading to a significant shift in sentiment for lenders,” it said.The brokerage said that the structural adjustment to bank valuations is still a work in progress. It said that with the growth rates and RoEs in the mid-teens, the fair value for large banks is 1.5-1.7x PBV compared to 2-2.8x currently. “Banks will continue to derate till they settle at these valuations,” it said.DSP Asset Managers’ Gada believes that if banks can demonstrate consistency and predictability, investors may find these stocks attractive and pay a premium. “The proof of that we will get to see in the rate down cycle, where extraordinary earnings will get normalised,” he said.