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The Economic Times Title : Guest Column - Credit Research Can be a Valuable Tool for Picking the Right Stocks Author : ANANDA BHOUMIK Location :

Article Date : 11/05/2014

In the recent rally in bank stocks, lenders with superior credit fundamentals and beaten down valuations gave better returns than weaker banks. This supports the through-the-cycle approach to rating that India Ratings follows and suggests a possible lead indicator for stock picking.

The premise is fairly intuitive: investors are more enthused about strong banks that are expected to outperform the weaker ones. The question is which lead indicators to pick: since banks' performances are strongly correlated with the economy and with rate cycles, it is necessary to segregate the analysis of pro-cyclical elements of a bank's balance sheet from features with different long-term drivers. The stress test and funding gap analysis that India Ratings carries out are two useful tools that facilitate such differentiation.

The hypothesis is particularly striking for banks whose price book ratio was less than 0.5x at the beginning of the rally in February. Annualised returns on stocks (excluding dividends) between February and October ranged between 25% and 40% for banks that fared better in Ind-Ra's stress test and funding gap analysis. In contrast, banks that did not perform as well in the credit tests delivered significantly lower returns of between 5% and 20%.

Figure 1 helps identify banks that provided superior returns in a peer PBV set. Stocks of PNB, Union Bank, Canara Bank and Indian Bank did better than that of Allahabad Bank, IDBI Bank or Vijaya Bank. The first set of banks outperformed the second in the stress test analysis published in October 2012 for a variety of reasons.

The stress report, available on our website, analysed banks based on their susceptibility to credit risks from cyclical sectors, infrastructure lending and single name concentration.

These were than compared with the buffers that banks have by way of adjusted pre-provision operating profits (first level of protection) and then equity capital to be able to absorb any sudden shock in credit costs. The banks that performed better in the stress test did so typically due to lower concentration levels, superior risk-adjusted pricing and better capital buffers.

The superior returns on their stocks also indicate greater flexibility in raising equity, which strengthens their performance in the stress test.

The report suggests banks with lower funding gaps tend to reward shareholders better during a bull run. In June 2013, India Ratings published a report comparing the cumulative one-year funding gaps that banks ran; banks with wider gaps were exposed to greater refinancing risks and potentially volatile NIMs during periods of tight liquidity.Investors seem to have sensed better growth opportunity for banks with lower refinancing risk and better liquidity . Andhra Bank is an interesting example the bank performs reasonably better on the stress test but the stock deliv ered a below-average return of 13%. The reason could partly be explained by the s t re s s o n i t s funding side, where the gap was amongst the largest for Indian banks.

What about private banks whose standalone performances have been among the best in the industry? Their stocks have performed well but not outstandingly so in terms of annualised retur ns. This is perhaps explained by their already high valuations at the beginning of the rally, indicating these scrips

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were already “discovered' and well researched, which may have squeezed out most of the information gaps.

Market validation provides a useful feedback to the rating process, more so now when government banks will need to potentially double their stock of common equity capital over the next four years to meet the Basel 3 guidelines. Any breach of the minimum capital ratio may lead to a deferral in the hybrid tier 1 instruments, leadi n g t o t h e i r d o w n g r a d e.

F lexibility to raise equity through strong market support is a vital input in determining the standalone creditworthiness of a bank. A quick-andeasy measure can be the PBV, particularly a sustained level of above average valuation.

For banks with weak valuation, an above-average performance in a bull market indicates improving access; however, these banks may remain hostage to market conditions unless their valuations improve on a sustained basis. This is the case with most PSU banks, which puts greater onus on the government to inject the required capital.

Equity injection in government banks will be critical from 2017, when most of the Basel 3 deleveraging will start to kick in for Indian banks. Tier 1 levels need to significantly improve by then, else government banks may struggle to raise growth equity, leading to a credit squeeze in the economy. That may well prove to be an opportunity for private banks and NBFCs to exploit.

to be an opportunity for private banks and NBFCs to exploit.
to be an opportunity for private banks and NBFCs to exploit.
to be an opportunity for private banks and NBFCs to exploit.

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