Insights

FundsIndia Views: When Pain Is Good

February 17, 2016 . Vidya Bala

With the Nifty down over 18 per cent in the past one year, we have been talking of many factors that triggered the pull down and what you should do. (Read our detailed note on this here.)

But if we leave out all the macro-economic and external factors, and get down to the brass tacks on what’s pulling down your fund’s performance, you will see it is predominantly influenced by one sector holding – banks.

Banks are a key indicator, and are also a reflector of economic, corporate and stock performance. They are large companies that broadly reflect the performance of corporate India and the Indian consumer’s discretionary spends, and are amongst the largest stocks in the listed space. Bank stocks receive maximum weight in the index, and therefore, fund houses seldom miss out on holding them in equal weight. At best, funds marginally deviate from index weights. This sector, therefore, makes or breaks the moves of the market.

The contrarian approach

While many funds reduced their exposure to banks, they still hold an average 20 per cent exposure against the 23 per cent exposure in the Nifty. In fact, some funds (from our Select Funds list), such as BNP Paribas Equity, Franklin India High Growth Companies, ICICI Pru Focused Bluechip Equity, and BNP Paribas Equity turned contrarian, and actually went overweight by increasing their exposure to the banking space over the past one year. Others such as Franklin India Bluechip, Franklin India Prima Plus and UTI Equity reduced their exposure marginally, while still holding higher exposure (that means being overweight) to the sector when compared with the Nifty.

The pain and clean up

Banking stocks have been beaten down for two reasons: one, higher Non Performing Assets (NPAs), and two, the need to be recapitalised, especially Public Sector Undertakings (PSUs).

This December’s quarter earnings have clearly shown that banks have decided to clean up their books, at least for a good part. While a few such as Bank of Baroda, Bank of India and Indian Overseas Bank ended with massive losses for the December quarter as a result of further providing for NPAs, others such as Punjab National Bank or Canara Bank have seen a massive drop in their net profits to insignificant levels.

This action by banks, when seen alongside a recent speech by the RBI Governor, Raghuram Rajan, and Deputy Governor, S.S Mundra, at a CII Banking Summit, give us some insights on this act of clean up, and what it could bring. The RBI Governor has stated that some banks decided to move faster so as to be put the problem behind them. The massive write-offs that we saw for the December 2015 earnings quarter are the result of banks’ willingness to clear the mess. This pain, of course, led to the banking stock being battered (BSE Bankex fell 20 per cent year to date while the Nifty PSU Bank Index fell a massive 34 per cent as of February 15).

Before we speak of what after the clean up, it is important to know that there are benefits from this build up of bad loans and their clean up. One, as a result of the burden, banks shied away from lending aggressively in recent years, and hence, it is likely that there is no fresh build-up of bad loans. As a result, the loans given now and in the near future would have likely passed all stress tests.

Two, in the words of the Governor, classification of loans as NPAs, can be an effective trigger for promoters to either raise equity capital to survive as well as revive projects, or for the local government to chip in to revive in case of delays in projects.

The revival

While banks’ balance sheets will, no doubt, have to be recapitalised, the question has been – when will such capital be infused by the Centre for banks. This clean up act could well be the signal for such recapitalisation. In the words of the Governor, “We have mapped out a variety of scenarios on possible outcomes. The Finance Minister has indicated he will support the public sector banks with capital infusions as needed. Our estimate is that Government support that has been indicated will suffice. Our various scenarios also show private sector banks will not want for regulatory capital as a result of this exercise.”

The above assurance, coming as it does, from the RBI, suggests that the extent of requirement and the possibility of it being met by the Centre has already been analysed under different scenarios, well enough. A clean up and recapitalisation of banks can well ensure availability of credit at rates that are also comfortable for the borrower, and thus, encourage borrowing and capital investments.

The larger revival

If that can be said of banks, it is more important to know about the revival in corporate earnings. The following data, presented by the RBI deputy Governor provides some insights. As seen below, and contrary to popular belief, it is not the small and micro industries that have been non-performing. A chunk of the NPAs (also because of their size) is from medium and large companies.

img_feb17

That takes us back to the fact (as history suggests) that when large and medium companies are classified as NPAs, they do not perish nor die; they take efforts to raise equity capital, be funded, and also push governments into action (especially when the projects involve large investments in states). Since a chunk of NPAs were from this segment, what will be seen is a revival in these companies and their projects, a leaner debt structure, and room for their own clean up, thus providing them leeway to raise money. In the words of the Governor, “If loans are written down, the promoter brings in more equity, and other stakeholders like the tariff authorities, or the local government chip in, and the project may have a strong chance of revival, while the promoter will be incentivized to try his utmost to put it back on track.”

Fine, this is something that can be expected to happen. But here is a surprise. Contrary to popular belief that credit growth has been poor, and hence, no corporate activity has been happening, credit growth has indeed happened in segments. While PSU banks saw industry credit growth of 3.3 per cent in 2015, private sector banks’ exposure to industrial credit grew by a good 14.6 per cent – far ahead of the single digit growth seen for the industry as a whole.

That means that there is off take of credit and at a healthy pace, suggesting revival in corporate borrowing and investing activity. The bad loan clean-up of public sector banks can also spur them to resume the lending they had been wary of until now. Now, this suggests that growth, at a very nascent stage, is underway. If and when markets see this signal keeping aside other global factors, the market will take off with élan.

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.

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