Does HDFC Bank Deserve to Trade at Historic Lows? 

It was the 3^rd of April 2020.

The first signs of the Coronavirus pandemic were already visible. There were rumours of an impending lockdown.

Businesses across the globe were beginning to battle an unprecedented crisis.

Stock markets nosedived at every sign of bad news from China.

And in the midst of this, one of India's premier private sector banks rolled out few more digital services.

But its valuations crashed to multi year lows.

HDFC Bank has never been completely immune to stock market crashes. Whether in 2009 or 2020, shareholders took the stock of the banking entity to the cleaners, at every crisis. After all, no business is as closely linked to the economy as banking.

Also, despite HDFC Bank's reputation for consistency in asset quality and profit growth, the bank has been at the receiving end of investor apathy from time to time.

But what explains the fact that in 2023, when Sensex and Nifty are near all time highs, the stock of HDFC Bank is once again at rock bottom valuations?

Agreed, the bank is no longer its old nimble avatar. Rather the reverse merger with parent HDFC Ltd has brought the bank sufficient near-term challenges.

Being the seventh largest bank globally does come at a cost. But HDFC Bank is no stranger to growth and acquisitions. Rather from its early days the bank has absorbed relatively smaller entities like Times Bank and Centurion Bank. And every time the synergies have paid shareholders rich dividends.

In 2023, the troubles, though in house, can cause some un-envisaged dips in margins and asset quality.

Not one to offer end moment surprises, the management of HDFC Bank chose to warn analysts about the possible bad news in coming quarters, at the latest concall.

But like it typically happens for consistent entities, even the slightest aberration, even for temporary period, is not pardoned. The warning of muted margins and slightly bloated NPA has sent the stock price back to April 2020 valuations.

Question is, does HDFC Bank deserve to trade such historic lows (price to book value below 3x)? Should its current shareholders panic? And more importantly can this be an opportunity for value buying?

Now, as potential investors, you need to conduct detailed due diligence on the stock to form your view.

But this is not about a buy or avoid view on HDFC Bank.

Rather it is about drawing up a checklist that helps you vet the distorted valuations of certain entities that a rely on macro factors.

Will the bank fund India's capex drive?

India's economic growth over the coming decade will be a mix of self and bank funded growth. Banks, especially private sector banks will pay a crucial role in the latter. The coming wave of capex in both public and private sector entities will keep credit demand steady. Being one of the most premier banks in the country with a strong network across domestic and overseas corporates, HDFC Bank is bound to be a significant lender.

Will Indian government continue to pursue financial inclusion?

Financial inclusion has been the key to both financialization and digitisation of the economy over the past decade. Applications like UPI have made banking services accessible to the remotest corners of the country. HDFC Bank has the first mover advantage in new technology initiatives, like the digital currency, for financial inclusion.

Will Indians continue investing in financial assets?

The share of financial assets in total household assets in India has doubled over the past decade. The trend is unlikely to reverse since financial investments are being incentivised.

Its exposure to non-banking financial entities like insurance and mutual fund, through subsidiaries, makes HDFC Bank well placed to capitalise on the trend of savings moving towards financial assets. Thid is turn offers the bank huge advantage of surplus low-cost deposits.

Will the banking sector get more competitive?

The emergence of the new HDFC Bank has invited comparisons with its global banking peers. But the sobering fact is that China's ICBC is still way ahead, especially since that country accounts for 15% of global trade.

However, domestically, over time, smaller Indian banks and NBFCs are expected to consolidate. Hence a large bank like HDFC Bank may feel the heat of competition from domestic peers looking to cannibalise on its market share. Nevertheless, with its profit focus, it is unlikely that HDFC will compromise on margins or asset quality for growth.

Coming to some specifics about how the merger will affect HDFC Bank...

Take disbursement growth...

HDFC Bank originates materially lower mortgages vs. other peer banks, as the bank was always an origination partner for HDFC Ltd. and the service capability/underwriting was always with HDFC Ltd. With the merger, these artificial constraints to growth will disappear. Hence the bank will be able to leverage upon its large footprint to originate more housing loans.

Mortgages are one of the largest segments within retail housing, HDFC Bank had a materially lower market share in housing relative to its own overall loan book market share (only around ~11% of its overall book is from housing). With the merger, the banks gets access to the largest market within retail loans and will further support its presence as one of the most dominant retail lender in the country. According to estimates (KIE estimates), the consolidated entity will have 20%+ market share in mortgages.

Then comes the ability to cross sell to a broader set of customers...

As per the HDFC Bank management, ~70% of the customers of HDFC Ltd. and its subsidiaries do not bank with HDFC Bank and ~8% of the HDFC Bank customers have mortgage product from other mortgage providers.

Post the merger, the bank will get access to a large pool of untapped customers who can be cross sold, both, mortgages and other products manufactured within the HDFC empire.

I am sure you are wondering...How about the financials of the merged entity...will they be better?

Going by HDFC Bank's history of mergers, even if there is a temporary dip in margins and return ratios ....they are unlikely to dent long term fundamentals

Merge Entity May Have Temporarily Muted Financials

More importantly, HDFC Bank's rigour in sustaining quality of assets will hold good over the longer term. Therefore, dent in book value due NPAs is ruled out.

The Aberration in Asset Quality Will be Temporary

Should investors shun HDFC Bank on the basis of near-term woes?

Since bank balance sheets and valuations are extremely vulnerable to non-performing loans, valuations can slip progressively.

It is the big 'I' that is to be blamed.

What Buffett calls the Institutional Imperative.

The 'I' is the tendency of companies to do things because everyone else seems to be doing it!

Buffett wrote in his 1989 letter to shareholders...

• My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative.

Even some of the biggest and reputed banks globally have fallen from grace as and when they were reported to be cheating shareholders with a rosier picture of their performance.

So, the fact that HDFC Bank is warning potential investors of near-term challenges should, in fact, be seen as sign of transparency and focus on long term value creation.

HDFC Bank has built its reputation of choosing quality over balance sheet size for nearly three decades. The fact that the bank has commanded premium valuation for most of the period shows investor trust in the bank's quality and consistency.

Hence, unless there is reason to believe that HDFC Bank has under reported margin challenge or asset quality, which could permanently damage its valuation criteria, there is no reason to shun the stock.

For investors with a very long-term perspective, looking for consistent compounders, there is no better opportunity for bargain hunting, than increasing exposure to contrarian bets like HDFC Bank.

Hope you like this video. Thanks for watching.