Legendary investor Benjamin Graham is the father of value investing. His investing principles though age hold, have relevance even in the current context. His principles are more quantitative and related to shifting between stocks and bonds as market conditions change. Though not sector specific Graham's approach made banks a suspect for investments. High leverage and business quality were the two main reasons behind it.
Let us analyze these two reasons in the Indian context to understand why banking as a sector lacks faith when it comes to structuring a portfolio on Graham's principles.
The United Bank fiasco has displayed that the regulatory controls which India boasted during the US banking debacle are not foolproof. The Indian banking system is perhaps plagued with bad assets and United Banks' case is not a one off. Fathom this. As per an article in Live Mint, Rs 4 trillion worth of loans have been recast through the corporate debt restructuring (CDR) mechanism. Further, non-performing assets (NPA) levels of 40 listed banks that have announced earnings till now have risen 36% YoY in the December quarter!
In short, stressed assets in the system are rising. Though much of the trouble is due to projects stuck for want of clearances and fuel shortages one cannot rule out top management's discretion in lending to troubled enterprises for a quid pro quo. Or there is simply a gross failure in assessing borrowers' credit worthiness. Whatever the reason we cannot ignore the United Bank episode as an isolated one and believe that the banking system is free of dirt.
Assessing the United Bank issue deeply will help us understand why. It is not that the depositors of United Bank are going to lose their money overnight. In the December ending quarter the non-performing assets (NPA) levels went up by 36% QoQ while the gross NPA were pegged at 10.8% of total advances.
The fact that a leeway was offered by the government to banks to not write down a problematic loans led to banks defer the problem for a prolonged period.
This indicates that a lot of camouflaging is done in the banking system. CDR is a classic example. Referring a loan to CDR may not require the same to be classified as an NPA in strict sense but the fact is that a section of the loan book has become junk. The recovery may take long and there is a possibility of write off.
Management's discretion with respect to recognizing a delinquency in United Banks' case was also a matter of concern. And as a matter of fact such discretionary powers are being used by top officials of other banks too. This does not give a true picture of banks' troubled portfolio and results in under-provisioning.
In short, transparency levels have been a big issue for banks due to management discretion in recognizing NPAs as far as India is concerned. Regulatory oversight was a big issue when it came to foreign banks which were the root cause of sub-prime crisis. Also, being a leveraged business the margin of error is low when it comes to identifying efficient banks. A few risky loans can increase provisioning requirements and wipe out the net worth.
Thus, by skipping businesses that are heavily leveraged, like banks and financial institutions, Benjamin Graham hedged his portfolio against the risk of debt default. What is more, companies with negligible debt are the most resilient to withstand weak economic cycles.