Avoid banks and NBFCs with high proportion of unsecured and SME loans

The banking and financial sector is among the worst hit in the current downturn. While the Nifty 50 has declined 27.1 per cent over the past three months, the Nifty Bank index has nosedived 39.4 per cent over the same period. The steep correction, however, presents longer-term investors with good entry points into quality stocks within this sector.  

This sector’s prospects are bound closely to that of the economy. And with economic growth poised to slow down considerably—the International Monetary Fund has projected a GDP growth rate of 1.9 per cent in FY21—the banking and financial sector will bear the brunt. There are fears of a spike in bad loans. “The market fears that the slowdown could lead to potential job losses. That could in turn cause stress in the retail loan books of banks. Similarly, loss of production could lead to stress emerging in corporate, SME (small and medium enterprises) and some of the other sectors impacted by this slowdown,” says Vinay Sharma, fund manager, Nippon India Mutual Fund. Adds Nitin Aggarwal, vice president research-banking sector, Motilal Oswal Institutional Equities, “With discretionary consumption likely to get affected, loan growth could slow down across segments.”

Many private-sector banks were trading at rich valuations prior to this downturn. “Now you have a situation where credit growth could slow down and gross non-performing assets (NPAs) could spike in certain loan segments over the next six-eight months. Hence, investors are reluctant to accord very high valuations to these entities,” says Jaikishan Parmar, senior equity analyst-BFSI, Angel Broking.

This sector tends to be heavily owned by foreign institutional investors. Their massive pull-out has led to heavy selling in these stocks.

Longer-term investors with a three-five-year horizon have an opportunity to pick quality stocks, which in calmer times tend to trade at exorbitant valuations. “Indian banks have cleaned up their asset quality over the past few years and the proportion of vulnerable assets held by them has declined. Lending standards have become more stringent. There is greater reliance on credit history to make lending decisions. While there could be slippages in asset quality and moderation in credit growth, these concerns are adequately reflected in current prices,” says Aggarwal.  

The sector’s longer-term prospects remain bright. The penetration of financial products is low in India, which provides ample runway for growth. In the past few years, new opportunities have arisen, like life insurance, general insurance, and asset management companies. Financial technology (fintech) companies could also get listed soon.

If some of the fears caused by the pandemic turn out to be unfounded, the sector could get re-rated rapidly. However, investors should not enter expecting a rapid turnaround. “Manufacturing companies can return to 80-90 per cent capacity utilisation in a couple of months once the lockdown ends. In case of the banking and financial sector, asset quality issues could emerge on past loans. This could affect earnings for the next three-four quarters,” says Parmar.   

Investors should focus on top-tier banks with reputed promoters and sound risk management abilities. “Deposit outflows from midcap banks have been reported. This money will move to larger banks, reducing their cost of funds,” says Aggarwal. Insurance companies may also be considered as the fear generated by the pandemic could lead to people purchasing more policies. Asset management companies may be considered provided they have not faced issues in their debt funds. Those with higher risk appetite may opt for gold loan non-banking financial companies (NBFCs), since the price of gold, their main collateral, is on the upswing. Avoid banks and NBFCs with a higher proportion of unsecured loans and SME loans, suggests Parmar.

Investors with at least a seven-year horizon may invest in a banking and financial sector fund having a consistent track record. However, exposure to a sector fund should not exceed 5 per cent of the equity portfolio.