Bank Stock Rally Isn't Done Yet, Says Marcellus’ Pramod Gubbi

Though shares of embattled lenders have seen a short-term spurt, high-quality financial stocks still have the potential for good returns as focus returns to underlying fundamentals, according to Marcellus Investment Managers’ Pramod Gubbi.

The banking rally has largely been a result of a recovery in lenders earlier mired in trouble, the founder of the portfolio management services provider told BQ Prime’s Niraj Shah. That has triggered rerating for such lenders, while “quality financials” have failed to shine.

The Bank Nifty has hit 52-week highs, surging more than 20% in the past year compared with a little over 3% rise in the benchmark Nifty 50.

The performance, however, is skewed toward banks that were historically facing bad-loan trouble, he said. It's a "one-off recovery" after a long period of correction as they "held back credit growth, preserved capital, recapitalised by raising money from the market".

Once they stopped credit growth, they were able to provide for some of their "old problems" and then came capital infusion, according to Gubbi. "Lending discipline was only “one half of the solution”.

“Also, serendipity is a factor here," he said. As steel prices rallied, several banks with massive steel NPAs benefited because of recoveries from written-off bad loans, providing a "big earnings boost,” Gubbi said.

That, however, won't lead to sustainable earnings growth “because you’ll have to have a continuous source of NPAs which will go bad and then become better”.

Better-quality banks, on an absolute basis, haven’t done really that well, he said.

“I’m talking about HDFC Bank and Kotak Bank, which we own for all our clients and most of us own in our portfolios as well," Gubbi said. Multiples have contracted for a couple of these lenders even as their underlying earnings growth has been consistent with their past and is now accelerating as well, he said.

While the troubled lenders have reaped the one-off benefit from recapitalisation and write-offs, they will now be measured on the pace of their credit book growth, strength of their liability franchise, and margin expansion in a rising interest rate situation, he said.

Quality financials can still offer "good returns" as earnings growth remains strong and will only pick up along with the underlying economy and credit growth, he said. Margins will expand as interest rates rise on the assets side and remain sticky on the liabilities side, he said. Going by past record, their NPAs are likely to stay low for, he said.

Investors, he said, will have to be patient as the asset quality weakness will only become apparent after one lending cycle.

Credit Growth Prospects Strong

While any global economic crisis will have an impact on India too, Gubbi said the country is relatively insulated to such adversities.

“We haven’t been a largely export-dependent economy unlike some of our Southeast Asian peers, or China, or Brazil for that matter, nor is capital that much globally dependent for India as an economy,” he said. “Over the last decade ... Indian households have moved their savings from real estate and gold toward financial assets, which is bank deposits, mutual funds, direct equities, insurance, and so on.”

“The cleaning up of the banking sector has put us in a great position to drive credit growth,” he said. “Capital adequacy for the banking system today is at its all-time high."

Insurance Sector

According to Gubbi, optimism over improvement in India’s per capita income indicates strong penetration prospects for life insurance. Within general insurance, the opportunity is "fairly immense” for the motor segment, he said.

“[But] You have to be careful in terms of choosing the play here," he said. "You have to choose very high quality underwriters, at the same time you have to choose companies which can make a very healthy return on the float that they’re sitting on.”

Watch the full interview here: