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The Economic Times Title : Guest Column - Credit Research
Can be a Valuable Tool for Picking the Right StocksAuthor : ANANDA
BHOUMIKLocation :Article Date : 11/05/2014
In the recent rally in bank stocks, lenders with superior credit
fundamentals and beaten down valuations
gave better returns than weaker banks. This supports the
through-the-cycle approach to rating that IndiaRatings follows and
suggests a possible lead indicator for stock picking.
The premise is fairly intuitive: investors are more enthused
about strong banks that are expected tooutperform the weaker ones.
The question is which lead indicators to pick: since banks'
performancesare strongly correlated with the economy and with rate
cycles, it is necessary to segregate the analysis ofpro-cyclical
elements of a bank's balance sheet from features with different
long-term drivers. The stresstest and funding gap analysis that
India Ratings carries out are two useful tools that facilitate
suchdifferentiation.
The hypothesis is particularly striking for banks whose price
book ratio was less than 0.5x at the
beginning of the rally in February. Annualised returns on stocks
(excluding dividends) betweenFebruary and October ranged between
25% and 40% for banks that fared better in Ind-Ra's stress testand
funding gap analysis. In contrast, banks that did not perform as
well in the credit tests deliveredsignificantly lower returns of
between 5% and 20%.
Figure 1 helps identify banks that provided superior returns in
a peer PBV set. Stocks of PNB, UnionBank, Canara Bank and Indian
Bank did better than that of Allahabad Bank, IDBI Bank or Vijaya
Bank.The first set of banks outperformed the second in the stress
test analysis published in October 2012 for avariety of
reasons.
The stress report, available on our website, analysed banks
based on their susceptibility to credit risksfrom cyclical sectors,
infrastructure lending and single name concentration.
These were than compared with the buffers that banks have by way
of adjusted pre-provision operatingprofits (first level of
protection) and then equity capital to be able to absorb any sudden
shock in creditcosts. The banks that performed better in the stress
test did so typically due to lower concentrationlevels, superior
risk-adjusted pricing and better capital buffers.
The superior returns on their stocks also indicate greater
flexibility in raising equity, which strengthenstheir performance
in the stress test.
The report suggests banks with lower funding gaps tend to reward
shareholders better during a bull run.In June 2013, India Ratings
published a report comparing the cumulative one-year funding gaps
that
banks ran; banks with wider gaps were exposed to greater
refinancing risks and potentially volatileNIMs during periods of
tight liquidity.Investors seem to have sensed better growth
opportunity forbanks with lower refinancing risk and better
liquidity . Andhra Bank is an interesting example the bankperforms
reasonably better on the stress test but the stock deliv ered a
below-average return of 13%. Thereason could partly be explained by
the s t re s s o n i t s funding side, where the gap was amongst
thelargest for Indian banks.
What about private banks whose standalone performances have been
among the best in the industry?Their stocks have performed well but
not outstandingly so in terms of annualised retur ns. This
isperhaps explained by their already high valuations at the
beginning of the rally, indicating these scrips
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were already “discovered' and well researched, which may have
squeezed out most of the informationgaps.
Market validation provides a useful feedback to the rating
process, more so now when governmentbanks will need to potentially
double their stock of common equity capital over the next four
years tomeet the Basel 3 guidelines. Any breach of the minimum
capital ratio may lead to a deferral in thehybrid tier 1
instruments, leadi n g t o t h e i r d o w n g r a d e.
F lexibility to raise equity through strong market support is a
vital input in determining the standalonecreditworthiness of a
bank. A quick-andeasy measure can be the PBV, particularly a
sustained level ofabove average valuation.
For banks with weak valuation, an above-average performance in a
bull market indicates improvingaccess; however, these banks may
remain hostage to market conditions unless their valuations
improveon a sustained basis. This is the case with most PSU banks,
which puts greater onus on the governmentto inject the required
capital.
Equity injection in government banks will be critical from 2017,
when most of the Basel 3 deleveraging
will start to kick in for Indian banks. Tier 1 levels need to
significantly improve by then, elsegovernment banks may struggle to
raise growth equity, leading to a credit squeeze in the economy.
Thatmay well prove to be an opportunity for private banks and NBFCs
to exploit.
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