Rally in public sector banks driven by optimism

Rising bad loans and weakening margins do not justify the rally

Through 2011, stocks of public sector banks were pummeled mercilessly as bad loans kept rising and net profit decelerated. So badly hammered were the shares of these banks that many were trading below their book value towards the end of the year.

So, when the markets switched to a risk-on mode in January this year, shares of state-run banks jumped by nearly 50 per cent, but are now down by 10 per cent since last week. With crude oil prices beginning to trend higher and fears of inflation making a come-back look real, sanity seems to be returning to the markets.

While beaten down valuations are fairly good reason to buy shares, market pundits are fast veering around to the view that fundamentals matter. And in case of public sector banks, stock prices seem to have run ahead of fundamentals, claim experts.

Apart from valuations, a key reason for the run-up in prices also is the expectation of a cut in interest rates. The global cycle seems to be placed in a similar situation as it was in 2009 – with central banks expanding their balance sheets and liquidity rushing to emerging markets as interest rate cuts started in those economies, too.

However, this time around, the financials of public sector banks don’t look as robust. Between June 2008 and March 2009, the gross bad loan ratio declined and net non-performing loan ratio increased only by six basis points.

During this period, loan growth, too, remained close to 25 per cent and net interest margins (NIMs), too, expanded. In contrast, Avendus Securities says 2012 may expose public sector banks to headwinds from a rise in non-performing loans, slowing loan growth and a decline in NIMs.

The consensus estimates on profit growth of CNX Public Sector Bank in 2011-12 has declined 3.2 per cent in January to 11.1 per cent year-on-year. In addition, provisions for non-performing loans also jumped.

In the December quarter, public sector banks saw a 1.5 per cent sequential rise in net non-performing loans/networth to 18.2 per cent, while it remained largely stable for new banks at 2.8 per cent, says Avendus.

Even though the government has taken steps to prevent the crisis in the power sector from escalating, analysts believe stress in other sectors may continue to be an overhang for PSU banks.

Spark Capital says, “Avoid most PSU banks. Doubts remain on the credibility of the ABVs. We prefer infra non-banking finance companies to PSU banks as a better bet on possible asset quality improvement. Buy PSU banks if they are trading below 1x FY13E stress tested ABV. Retail asset biased private banks remain well insulated.”