Join this party at your own peril

Jan 3, 2015

In this issue:
» Are Indian banks' valuations and fundamentals well aligned?
» A prediction bigger than the subprime crisis
» Why oil could go to US$ 30 a barrel...
» Roundup on global markets
» ...and more!

  Chart of the day
It is not the first time that investors are intoxicated by stocks from the financial sector. And it is certainly not unusual for investors to directly correlate India's growth story with the potential in banking stocks. However, what stands out like a sore thumb is the inverse correlation between the change in fundamentals of Indian financial institutions and their valuations over the past year.

Banks in India typically become investor favourites every time the GDP growth inches up or the interest rates peak. For given the level of under penetration of credit, even a minor change in macroeconomic variable turns out to be a big catalyst for banks' profitability. To add to that, the government and RBI are keen on financial inclusion. This would mean licenses for new banks and additional branches for the existing ones. Plus there are several categories of financial institutions that were not listed even 5 years back. This includes gold loan companies, micro finance institutions and entities specializing in loans to self employed individuals. Thus investors are spoilt for choice when it comes to choosing high growth stocks in this sector in a rising GDP scenario. Needless to say these incentives have enticed investors enough to pay premium valuations too. And while stocks across sectors have seen a sharp run up in the past 6 months, those from the financial sector top the list.

Valuations of banks and NBFCs in India, are currently higher than most of their emerging market peers. Especially so, when compared on the basis of return on equity (RoE). Indian banks are trading at 3.1 times expected book value for 2015, while having an average RoE of 10%. In comparison, banks in China, Brazil and Argentina are trading closer to 2 times 2015 book value while sporting over 20% RoE. The latest IMF report too confirmed that Indian lenders' provision coverage ratio at 47% was amongst the lowest in emerging Asia. With NPA ratio at 4.5%, the laxity in provisioning is a major risk.

These statistics, however, have been overshadowed by the optimism about India's economic revival. The government has promised better management of PSU banks. Also its efforts to bring banks at the centre of India's financial evolution makes the future of Indian banking seem better than any other.

Hence, as investors lose track of reality in the greed of rosy expectations, they seem to be joining the party too late. And as was the case with the earlier bubbles, be it technology or subprime, it is the retail investors who will be caught in the euphoria until it is too late to exit. So according to us, it is not the time to join the party with banking stocks. Even though the future seems bright you would rather buy the most sound entities when the valuations are reasonable.

Inverse correlation of banks' return ratios and valuations

Do you think the optimism about India's financial sector is overbought? Let us know your comments or share your views in the Equitymaster Club.

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He was the first person to predict the onset of subprime crisis and people paid no heed to him. Yes, we are talking about Nouriel Roubini who now seems to have another bold forecast up his sleeve. And if this proves to be correct its repercussions would be even grave than that of the subprime crisis. The prediction relates to labor displacement caused out of industrial revolution. As more and more technological advancements take place machines would replace humans. In such an era, if the technologically induced displaced labor is unable to upgrade itself in terms of technical skill set it may suddenly find itself out of job. And this unemployment scenario can be much worse than what any recession would bring. The reason being technological advancements take away jobs permanently. In case of recessions, unemployment is temporary.

It is not that such a situation is being faced for the first time and technological advancements should be curtailed to keep labor force in the system. In the past too, world has coped with industrialization. However, this time the challenge is a bit different as we move to a digital era where literacy and skill set are the two most important parameters needed to stay employed. If the new generation is not able to cope with this challenges we may well see an unemployment subprime!

What a big difference the last 6 months has seen for oil prices. In July 2014, oil was trading at around US$ 100 a barrel. Now, it has plunged to around US$ 53 a barrel. Not surprisingly, questions are being raised whether this oil slide will continue. As per an article on CNN Money, oil prices could very well slide to US$ 30 a barrel.

So why has the fall in oil prices not bottomed out yet? It is well known that a glut of shale gas from the US has been one of the primary reasons for the fall in prices. But that is not all. Saudi Arabia has not cut oil production either. So there is an oversupply of oil in the global market. Saudi Arabia's ruse is centered around driving the US shale producers out of production. This is led by the fact that shale oil production is much more expensive. That is as far as supply is concerned. On the demand front, things are not looking to rosy either. One of the biggest guzzlers of oil so far viz., China has seen its economy slow down. And with this, the demand for oil has also taken a hit. The other reason attributed to the drop in global demand is that mature economies have become more fuel efficient. And so, geopolitical tensions do not spark the same kind of panic on oil prices that they did earlier. The fact that oil has also emerged as an asset class has also contributed to how the oil prices move. In the current scenario for instance, as investors dump their holdings in panic, oil prices have fallen. All of these point out to the fact that we may not have seen an end to the oil slide yet.

The major global stock markets closed the week on a mixed note. The US indices ended the week in the red (down 1.2%) after breaching 18k level during the last week for the first time. This was mainly due to tepid economic conditions, as construction spending unexpectedly fell 0.3 % in November, while growth in the U.S. manufacturing sector slipped to a six-month low in December. Weak economic data also weighed on European stocks. However, the losses were mitigated on account of rising expectations that European Central Bank would take some measures to boost the euro zone. The stock markets in France and Germany witnessed a decline of 1.0% and 1.6% respectively during the week.

The major Asian stock markets reported gains gains during the week led by China (up 2.5%) and India (up 2.4%). This was despite the weak manufacturing data from China. The stock markets in Hong Kong were up 2.2% over the week. One of the factors driving these gains was the speculation that the government will relax monetary policy to boost growth.

The New Year seems to have started on a good note for Indian stock markets that closed higher by 2.4% over the week. The gains were mainly supported by hopes of reforms, especially in the banking sector. The HSBC Purchasing Managers' Index (PMI) rose to a two-year high of 54.5 in December led by strong order books, suggesting that the business conditions in India have improved at a faster pace. However, the survey indicated that the job market remains tight. All sectoral indices ended on a positive note with stocks in the capital goods, consumer durables and power sector leading the gains.

Performance during the week ended January 2, 2015
Data Source: Equitymaster & Yahoo Finance

 Weekend investing mantra
"If the job has been correctly done when a common stock is purchased, the time to sell it is almost never".- Philip Fisher

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee.

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1 Responses to "Join this party at your own peril"


Jan 3, 2015

Banks are the most untrustworthy animals given the past 65 years ( Political manipulations by successive ruling rouges of unethical lower caste popular theory of looting at the cost of genuine people) of independent country,s existence. This is the time people think twice before putting all the fruits in one bag called banks. Use banks only bare minimum needs.

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