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WF: While your note talks about the NPA cycle having peaked, most experts expressed concerns over the very small allocation in this Budget for recapitalizing PSU banks, indicating perhaps that we haven't yet seen effective resolution to the NPA problem, particularly amidst PSU banks - and that credit offtake will be impacted as a consequence. Can you help us understand the seemingly conflicting views here?
Shrey: Lower capitalisation for PSU Banks is not as negative as it is being perceived. The significant fall in yields over the last two years has resulted in good amount of gains on the banks' bond books. Further, PSU banks are also being encouraged to sell non-core assets. Gains from both these sources can offset the lower capital infusion.
NPA resolutions are as such independent to this issue and we believe they will happen over the medium to long term. Low credit growth today is more of a function of low economic growth and risk aversion (led by mounting NPAs) than capital availability. Once cyclically the demand drivers for credit normalises there is enough capacity for the banking system (including private sector and SBI) as a whole to support it.
WF: Market leadership within the banking space changed hands in recent months from retail banks to corporate banks. Would this mean that re-rating within the sector is now done and from hereon, it will be only earnings that will drive it forward?
Shrey: In times of uncertainty, certainty gets overpriced. Some of these retail banks have displayed reasonable certainty in their growth profile as compared to their peers and hence the re-rating. Corporate banks have caught up to some extent, but still have a long way to go. Going forward while earnings will be a key valuation driver, we believe there is immense scope of multiples expansion in the banking sector as a whole, and more specifically in certain areas like the corporate banking leading to re-rating possibilities.
WF: NBFCs took a big knock upon demonetization. What were the key issues, how have these been resolved/addresses and which categories of NBFCs are now in your buy and avoid lists post demonetization?
Shrey: Most of the NBFCs cater to the cash intensive earn-and-pay segment, which did get temporarily disrupted due to Demonetisation. We believe that it is temporary, and the situation will normalise in the near term. However, it is worthwhile to note that given that the customers are of earn-and-pay profile, there can be some permanent loss of revenues during this adjustment phase of demonetisation. This will however reflect with a lag as the Central Bank has given a forbearance to delay NPL recognition for small loans.
WF: Structurally, there is a view that the embedded value of large branch networks is on a secular decline as digitization of finance gathers momentum. Do you agree with this view? How does this impact valuations of the banking sector?
Shrey: Digitisation, at this point, is achieving two large outcomes: one being, better convenience and second being, ease of doing business led by faster turn arounds. Hitherto, bank branches were the focal service delivery outlet. Now, there is that much more bandwidth available, given that digitisation encourages self-service by customers, to start positioning branches as an even more stronger marketing delivery outlet. This transition would only mean that branches would be more evaluated on new customer acquisition and cross-sell opportunities than customer service. Given the under-penetration of banking service, we believe the embedded value of branch network stays, although the driver of the embedded value has changed from customer service to customer sourcing.
WF: While the economic growth story from hereon is quite compelling, how convinced are you about valuations in the banking space now? Has the market already priced in a good portion of this expected growth?
Shrey: Markets often tend to have aberration in stock prices and valuations, more so in times of uncertainty. Further, often certainty tends to get overpriced. As explained previously, there are a few pockets which are being fairly valued for their certainty. However, there is still a substantial part the segment where PE re-rating and earnings growth possibilities are high. These are attractive opportunities from a medium term time frame. Further, we observe that when growth cycle turns it can surprise on the upside.
Projected high government spending and the surplus liquidity led by demonetisation would have a multiplier impact on the economic growth with a lag and would aid revival of corporate growth and profitability. Banking sector typically grows at 1.5 -2 times of the nominal economic growth and hence, we believe that the sector can deliver superior returns over the next couple of years.
WF: What is the key investment argument for your Banking Fund at this juncture?
Shrey: We expect corporate economic cycle to recover over the medium term, led by low interest rates and benign liquidity environment. Further the risk-reward equation is favourable given that we expect the uncertainty to reduce further in the medium to long term. Hence we are optimistic on the sector prospects and believe the fund is aptly positioned to gain from the recovery.
We are confident of our portfolio construct from the medium to long term perspective. Currently our portfolio is well positioned to capture this growth opportunity with approximately 40% allocation each to Corporate & Retail Banks along with allocations to Insurance, Niche NBFCs and Housing Finance Companies.
Thus the Reliance Banking Fund portfolio has an optimal blend of re-rating, earnings and niche plays to generate superior performance over the next few years. Reliance Banking Fund has demonstrated a strong track record over the last decade and more. Since its inception (May-2003) the fund has generated of 25% CAGR returns outperforming the broader markets during the same period (returns as of Feb 22, 2017).
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