In the last edition we made a comparison between Nifty and S&P 500 in terms on constituents. The weight of the banking sector in the Nifty is 25% while financials weight in the S&P 500 is 15%. The difference in weights does not indicate that banks weight in the Nifty is too high. However, the heavy weight of the financial sector in the Nifty makes it critical for the future performance of the Nifty. The question we are trying to address is that whether banks weight in the Nifty will go higher, remain the same or go down? If banks weight in the Nifty goes up, it is positive for the index as it has the potential to take the index higher. If it remains the same, the performance of the Nifty will be more or less in line with the performance of the banking sector. If the banking sector weight goes down, then Nifty can have a problem unless some other sector makes up fast for the loss in weight.
The Indian markets are giving higher weight to growth than to size. State Bank of India (SBI), which is the largest Indian bank in terms of balance sheet size, is valued 50% below that of HDFC Bank, which is one fifth of SBI size. HDFC Bank is promoted by the mortgage lender HDFC and together the two lenders have around 10.5% weight in the Nifty. The two lenders stated aim is to grow between 20% to 30% every year and they have been consistently growing at such rates for the last many years.
The other big lender ICICI bank, which is the second largest lender in the country after SBI, is valued below that of SBI. The reason is that ICICI bank went into a defensive mode after the 2008 debt crisis, where it was affected by liquidity tightening. The highest valuation is given to Kotak Mahindra Bank, which is a small private sector bank as compared to the others. There is a good bit of takeover premium attached to Kotak Mahindra Bank, hence the high valuations.
Indian bank valuations include that of subsidiary company valuations. All the banks in the Nifty have presence in asset management, insurance, broking and investment banking. HDFC runs the second largest asset management company in India while ICICI bank runs the largest private insurance company in India. There is a good bit of cross selling across the financial services platforms. The financial sector weight in the Nifty includes the growth potential of asset management, insurance, investment banking and broking.
The banking sector weight to stay the same or increase in the Nifty should grow at the pace at which it grew over the last decade. That would mean a growth rate of almost 30% annually. It is a difficult task to achieve as the base has become higher. The banking sector is also highly regulated with 30% of NDTL (Net Demand and Time Deposits) take away due to statutory obligations. The positives going for the sector is the use of technology, which is very high. Technology expands reach as well as reduces cost of delivery. The negatives for the sector is the regulation as well as cyclicality in terms if inflation and interest rates.
India’s GDP growth has been in the 8.5% to 9.5% range in the period 2004-2009 and this high growth period has resulted in good growth for the banking sector. Deposit and credit growth in that period has averaged 19% and 26% respectively. Private sector banks outpaced averages through better service delivery and right pricing. However, since then state run banks have embrace technology and are competing aggressively with the private sector banks for deposits as well as credit.
Going forward, private sector banks will have to strive hard to justify valuations. If the overall economy improves, the banks will do well with more traction for state run banks given valuation differential. If the economy falters then banks too will suffer and weights in Nifty will come off overall.
Top banking pick for the future will be ICICI bank as it has come out of a difficult period and is focused on regaining its position as the top private sector bank. It has the right technology to deliver growth. Valuation too is relatively low at 2 times price to book.
On the whole banking sector is not likely to lead the Nifty higher unless there is a surge in GDP growth or there is exceptional service delivery both of which do not seem likely in the near future.