Investors Beware – 3

The financial sector has massively underperformed the broader markets in past three months. A number of experts have called for increasing exposure to this sector in view of this underperformance. They have argued that valuations are now discounting the worst in terms of COVID-19 related delinquencies and the economic activity shall normalize in next 2-3 quarters. The consensus amongst experts is veering towards outperformance of the sector in next 12-15 months. It appears that many non institutional investors are in agreement with the experts’ opinion and have increased their exposure to the banks and NBFCs, especially the low priced ones.
I would like these investors take note of the following data points while increasing their exposure to the financial sector in India.
(a)   The capacity utilization of Indian enterprises peaked at 83% in 2011 and has ranged between 70-75% since then. It declined to below 70% in 2QFY20, much before the COVID-19 induced lockdown took place. The business sentiment is at multi year low, indicating that businesses do not see any sustainable rise in capacity utilization and need for capacity addition in short term.
Consequently, the project announcement has declined in past five years, from 17% of GDP in 1QFY16 to about 5% of GDP in past 4 quarters. The project completion rate has also declined materially.
This does not augur well for credit growth in the short term. Any growth in credit demand will come from mostly from consumption and working capital requirement. The quality of credit shall therefore remain under pressure, and ALM issues will persist.
(b)   Consumer confidence is at lowest since 2013, and the employment outlook has worsened materially. This shall keep the fastest growing credit category (personal loans) under check as the borrowers’ credit profile deteriorates.
(c)    The liquidity in the system is surplus, and it is likely to remain so in the short term. The call money rates are now closer to reverse repo rate, rendering overnight market competing with RBI.
Besides, the bond yields are now below bank lending rates, even though the benchmark G-Sec yields are well above the policy repo rate. This shall pressurize banks to liquidate some of their excess SLR portfolios and lend aggressively in the market. The pressure on return ratio may increase while the credit quality remains under pressure.
(d)   MF as source of corporate funding (especially working capital and promoter equity) has come under pressure due to a spate of defaults in past one year. This could bring some short term financing business back to banks. But the events of moratorium in case of Yes Bank and PMC Bank have left scare in the memories of depositors. They are increasingly veering towards larger banks, especially large PSBs. The cost of funds for smaller private banks may therefore rise in the short term.
(e)    The mutual funds and banks are wary of lending to non AAA rated borrowers, especially NBFCs. The cost of funds and availability of growth capital may remain a major constraints for these NBFCs, at a time when the delinquencies are expected to rise once the loan moratorium ends in August.
Personally, I would exercise little extra caution in making fresh investment in any financial stock. For asset allocation discipline, I shall stick to top 4 banks and top 4 NBFCs.

Author: Midas Finserve

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