Interesting trading opportunities in PSBs

The recent surge in public sector banks (PSBs) has created a momentum play where they look more attractive to traders. The differences in valuations between private banks and PSBs have reduced. Most PSBs trade at low valuations, while many private banks trade at high valuations. That differential could reduce.

In most sectors, analysts examine the price-earnings (PE) ratio as a basic measure. But, in the banking sector, price-book value (P/BV) ratio is more useful. Bank profits can be distorted due to provisioning for non-performing assets — banks have latitude in this regard. Net worth (which translates into book value per share) is a statutory condition for the sector, and has a much larger base and tends to be less affected by quarterly volatility.

Consider three sector indices. The National Stock Exchange (NSE) uses the last four quarters’ results to calculate PE and P/BV, etc., weighting constituents on the basis of free-float market capitalisation. The highly traded Nifty Bank contains four PSBs and eight private banks.

As of October 31, the Nifty Bank traded at a PE of 26.4 and a P/BV of 3.5. On September 29 (the last trading day in September), it traded at a PE 27.4 and a P/BV of 2.8. The price has risen four per cent from 24,053 to 25,019.

The Nifty Private Bank consists of 10 banks, including all eight constituents of the Nifty Bank. As of October 31, the Nifty Private Bank index had a current PE of 27.5 and a P/BV ratio of 3.2. The Nifty Private Bank index had a PE of 27.7 and a PB of 3.2 on September 29. The index was up 1.8 per cent in a month.

Many of the private banks have declared Q2 results in the interim period and higher profits and net worth have translated into stable valuation.

By global standards, a P/BV ratio of 3-plus is extremely high — banks are considered decent value at less than 1.25 times P/BV and conservative investors seek PBV of less than one since banking is exposed to every sort of risk carried by borrowers.

The Nifty PSU Bank index has 12 PSBs, including all four members of the Nifty Bank. On October 31, it had a current PE of 45 and a P/BV of 1.25. The Nifty PSU index had a PE of 36 and a P/BV of 1 on September 29. The difference indicates the surge in the pricelines since the recapitalisation plan. The index is up by a mind-boggling 24 per cent in a month.

The difference in valuations, coupled with differences in free-floats, has led to a paradoxical situation. PSBs own slightly over 70 per cent of all outstanding credit. But, they have very low weight in the Nifty Bank. Apart from low valuations, the free float is low.

Free-float methodology will eventually restrict the rising weight of PSBs in the Nifty Bank since the government stake will grow according to the recap plan. But, rising prices will counter that trend to some extent, and until the plan kicks in, the weight of PSBs will rise.

In September, the total weight of PSBs in the Nifty Bank amounted to only 10 per cent, less than one-third of HDFC Bank's weight of 34 per cent. By October 31, that weight had risen to 13.7 per cent, considerably higher.

Given momentum, traders are likely to stay long on the PSBs. Sophisticated traders will also carry out paired trades, shorting private banks and going long on PSBs at the same time. This could lead to a situation where the comparative importance of PSBs rises. 

It could present interesting opportunities for arbitrageurs.