The heavyweight Bank Nifty index has been languishing since the last two years, inching up merely 3 percent. But, among its constituents, stock prices of large banks and small public sector lenders have shown contrasting performance. To gauge if the outperformance of smaller PSBs versus large banks (PSBs and PVBs - private banks) can sustain, we looked at measures such as returns, operating performance, credit cycle, NPA movement, and provisioning trajectory.
In conclusion, we expect to see derating in smaller PSBs as the surge in other income, the primary driver of superior RoE (return on equity) in FY23 could be transient, while larger banks with better ALM (asset and liability management) positions and underwriting capabilities would outperform.
A peek into the business performance: One, business market shares (deposits + advances) of smaller PSBs declined in FY23 relative to both SBI and larger PVBs, but recovery of written-off loans drove up return ratios of PSBs. Two, large private banks sustained gains in business share (advances & deposits), credit cycle, and better underwriting track record in FY23. RoEs of PSBs rose significantly in FY23 (12 percentage points (pp) and 16.5pp for SBI & BoB, respectively) compared to those of PVBs (ICICI Bank up 4.7pp, HDFC Bank 0.08pp, Axis Bank -0.97pp and Kotak Mahindra Bank 1.38pp).
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Markets seem to have reacted differently: Shares of smaller PSBs nearly doubled and valuations surged by 50-60 percent, especially in the last 8-12 months. Amongst all PSBs, Bank of Baroda’s valuations benefitted the most from declining NPAs (correlation coefficient: -0.91). For instance, its business market share/total PSU share fell from 12.52 in FY20 to 10.26 in FY23, but P/B (price-to-book) more than doubled from 0.5x in December 2021 to peak level of 1.1 in December 2022.
Conversely, valuations of PVBs moderated during this period, even though PVBs (increased 0.6pp) scored over PSBs (average of 0.40pp) on NIMs, reflecting relatively better credit cycle. Major banks (SBI, HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and Axis Bank) saw de-rating during this period, in contrast to the re-rating seen in smaller PSU banks (PSBs). For instance, largecap like State Bank of India (SBI) underperformed and remained stagnant since October 2021; its P/B de-rated from a peak of 1.8x in November 2021 (trailing) to 1.5x currently. Likewise, large private banks too saw muted valuations.
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Will the dichotomy sustain? We gather, the valuation differential for smaller PSBs does not appear to be guided by fundamentals of business cycle and market power hypothesis. Rather, the rerating of smaller PSBs appears to be guided by RoE gains. The recovery from written-off loans classified under advance under collection account (AUCA; attributed to the past NPA cycle) was substantial for smaller PSBs in FY23 at 100-200 percent YoY, which contributed disproportionately to its net profits and hence, these banks delivered superior RoEs, notwithstanding their modest NIMs and pre-provisioning profits.
Given that these are legacy factors, they are expected to decline going forward. Small PSBs have risen to peak levels recently but the recent sell offs in small PSU banks appear to be blunting the re-rating momentum in the space in last 8-12 months.
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Smaller PSBs at peak valuations: Based on our study, we gather, holding pattern of PSBs (dominated by concentrated bets by certain FIIs) and fundamental factors such as recovery of written-off loans have caused return ratios and valuations of smaller PSBs to shore up. Further, a quarterly series of stock ownership, NPA ratios, yields on advanced, and cost of deposits indicate low contemporaneous correlation between valuations and spreads variables (yields, cost of deposits). There exists an inverse correlation between GNPA (gross non-performing assets) ratios and valuations, especially for Indian Bank (-0.82) and BoB (-0.91); SBI is at -0.54, but for other PSBs, it is less consistent.
Changes in shareholding patterns appear to have influenced the valuations of smaller PSBs. We envisage valuations of smaller PSBs could derate from the current level, as surge in other income, the primary driver of superior RoE for smaller PSBs could be transient, given that it comes from recovery of written-off bad loans. For SBI, it peaked out in FY21 and was down 25 percent in FY23 at Rs 7,692 crore.
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Larger banks may outperform: Evolving cyclical factors like sustained tightness in global rates, FII outflows, rising yield curve translating in trading losses, continued pressure on NIMs, and bottoming out of the NPA cycle would determine the performance of lenders, including banks and NBFCs. In this context, we believe larger banks with better ALM positions and underwriting capabilities will outperform. Overall, we maintain our underweight position for the BFSI sector.
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