PSU banks stage a comeback as tactical picks on sustained performance

The combination of low valuations and expected improvement in financials due to lowering credit cost is driving interest

It is nearly after 13 years that a foreign brokerage has resumed holistic coverage on stocks of public sector banks (PSBs). To that extent, Morgan Stanley’s report dated March 3, where the analysts have listed their order of preference for PSB stocks, is an indication that the state-owned banks may once again be attracting some interest, thanks to three back-to-back quarters of good results in FY21 so far. "State-owned banks' balance sheets have improved, and bad loans formation should moderate going forward,” the analysts note and this is the key reason for them to relook at their stance on PSBs. While State Bank of India (SBI) remains their preferred pick, stocks of Bank of Baroda (BOB) and Punjab National Bank (PNB) have been upgraded from ‘underweight’ to ‘equal-weight’. The brokerage maintains its underweight recommendation on Bank of India and Canara Bank.

For investors, the question is whether it signals a strong comeback in sentiments for PSB stocks or this move is a just a one-time revisit of stance.

Apart from SBI, whose share price has gained over 40 per cent in the past year, and returns are comfortably in the green even on a longer term 2 – 3 years horizon, the same isn’t the case for its smaller peers. In order words, unlike the private banks, it’s tough to draw a secular trend for PSB stocks as far as the rerating is concerned.  While in the past three months PSB stocks have appreciated by 30 – 40 per cent, Sridhar Sivaram, Investment Director, Enam Holdings says the sustainability of the rally is tough to call out at this juncture. “While there is a broad case made out for the PSBs, it’s not a structural narrative yet; it's more a case of recovery,” he explains.  
 

The average credit cost of PSBs in FY18 peaked at about 400 basis points (bps). In the December quarter of FY21, the number lowered to about 220 bps and Morgan Stanley expects a further 20 basis points easing by end of FY21 to 198 bps. By FY23, the expectation is that the average credit cost for PSBs will reduce to 127 bps, a level last seen in FY12. Analysts say that for every one per cent reduction in provisioning cost, it could boost the net profit by 3 – 4 per cent.

In addition to the potential earnings, PSBs trading at less than 0.7x book value, which makes these stocks a strong case to consider as a tactical buy. According to Sivaram, with every bank having massively provided for its legacy issues, “there isn't much trouble left, except for those which could crop up because of Covid”. The covid-related pressures could more be on the agri-loans, small and medium business loans and possibly mortgages. Slippages from corporate book, which accounts for over half of PSBs loan assets, is seen as quite negligible.

Yet, despite the optimistic outlook on earnings, if the Street lacks strong conviction on PSBs, it is for the want of structural reforms, such as a marked improvement in the underwriting practices or corporate governance standards. Analysts at Morgan Stanley note that the margin of safety on the potential bad loans absorption capability, given the availability of capital or provisioning buffer, is softer for PSBs compared to their private peers. “Margin of safety at PSBs (excluding SBI) is lower at 1–5 per cent; 6 per cent for SBI and over 10 per cent at private banks,” the analysts note.

So far, barring Canara Bank, other PSBs haven’t had much success shopping for equity. If PSBs prove their ability to raise capital independent of government’s infusion that would give a big leg up to sentiments. Street will closely monitor the success of BOB and Indian Bank’s fund raising due this fiscal, given both enjoy reasonable preference among domestic brokerages, to gauge if investors are indeed willing to put their money on PSBs turnaround story.