Pvt sector bank valuations likely to sustain: Morgan Stanley

Valuation multiples in the financials sector in India, particularly that of private retail lenders, are unlikely to de-rate unless there is a big downward cycle, feels Anil Agarwal, Head of Asian Financial Research of Morgan Stanley. In an interview with CNBC-TV18, Agarwal said he prefers private sector lenders with retail exposure over public sector banks and corporate-focussed lenders.He explained why private sector retail-focused banks may look somewhat expensive on traditional price-to-book valuation metrics but when looked at from a price-to-earnings basis, they were in line with averages."So even if the PE ratio were to sustain at 18-20 times, given 20-25 times profit earnings growth, you should see similar investment returns," he said, highlighting that the growth prospects of private Indian banks stood in stark contrast to the global financial sector where there was virtually no growth or even de-growth.

He acknowledged the shift of public sector lenders and host of new entrants has crowded the retail lending space, private lenders can still continue to gain reasonable market share.

“Earlier public sector lenders would cut interest rates to gain market share in any particular segment. But, with the minimum lending rate coming in, cutting rates often has become difficult, “ he says.Below is the transcript of Anil Agarwal’s interview with Latha Venkatesh on CNBC-TV18.Q: In a way you have a predictable preference. Yes for private sector banks and retail lenders, no for the corporate facing and definitely no for the public sector undertaking (PSU) lenders. But I just want to challenge that thesis. Let us take only the retail lenders. Now there is a lot of competition over there. You have got a whole lot of non-banking finance companies (NBFC), you have got the small finance banks and the public sector banks are all telling you that we are moving away from corporate to retail ¬– Punjab National Bank (PNB) tells you that, Bank of Baroda (BoB) tells you that. Is that not getting crowded now? Can you expect a lot of growth from the private lenders in the retail space?A: If you have talked to the state owned banks in the last two or three years, because the corporate cycle has been going on for some time, they have been talking about retail as a growth strategy for quite some time now. But if you look at the market share of the private lenders, it has kept going up. The way I think about it in the past, the service quality or the ease of financing from private banks is definitely much better than state owned banks. So, historically, the one tool which the state owned banks used to have to gain share, was interest rates. So, they could cut interest rates on specific products that they wanted to gain market share in. What has happened in this cycle is that because of the implementation of the minimum lending rate, banks cannot cut interest rates by a lot because if you cut interest rates on mortgages below Marginal Cost of Funds based Lending Rate (MCLR), you have to cut MCLR. So, the entire book gets repriced. And given the profitability challenges that the state owned banks are facing, they cannot cut rates. So, what has happened because of that is that while almost every bank is saying that we want to grow retail, barring one bank which is growing in line with the market, most of the other banks right now are still growing at a pace which is lower than the market.So my view would be that unless interest rates were to come down dramatically in these retail products, private banks will keep gaining share.Q: let me take that argument that this 19 percent growth in retail growth continues for the private sector banks. Even in valuations, HDFC Bank, even for that matter IndusInd Bank are a distance from what they were a year ago. HDFC Bank did not have a very great 2015, but still how much more can you give it over four times book. Kotak Mahindra Bank is over five times book. How much more can you give both these banks?A: I tend to look at price-earnings ratio (P/E) multiples because price to book, you need to look at it in conjunction with return on equity (ROE). Price to book by ROE is P/E. So, these stocks are trading at 18-20 times earnings which is not cheap. I am not trying to say they are cheap. But again, if you look at versus history, they are roughly around averages. There is only one bank which is above average right now. Almost everybody else is around average multiples. So, what is happening here, you have to think about it in the context of what financials globally. Right now when I look at financials outside of India, there is no revenue growth. In most of the markets right now, we are saying that the only revenue momentum is on the downside. So, here you are getting 20-30 percent revenue growth, so in that backdrop, I am not saying multiples will expand. Even if multiples sustain where they are, if you keep trading at 18-20 times earnings, earnings are growing at 20-25 percent, so you make 20-25 percent return which is not bad. I do not think multiples will derate in these stocks unless we have a big downward cycle in India. So, you are just compounding.Q: What about NBFCs? Again, they are the big beneficiaries of wholesale rates going down, so you can see that advantage. Is there still more to go in that space? We have seen a huge amount of growth space in Mahindra & Mahindra Financial Services (MMFSL) or Shriram Transport Finance Corporation or Bajaj Finance. It had gone through the roof. Will you still buy that stock?A: Forget about the ratings. But just in terms of the thematic what is happening in India is, coming to the point that you were making initially on state owned banks, just 70 percent of the market, they are not growing. You look at the loan growth irrespective of what they are saying, the loan growth is very weak. The other thing which people do not pay focus on is foreign banks. If you look at the foreign banks market share, it is 5 percent of the market, but they were pretty big in terms of a lot of these retail products. Four years back, in credit cards, foreign banks used to be 45 percent of the market on transactions, they are now 30 percent. So, foreign banks are losing share. So the result of which for anybody who has capital and ability to grow which means not saddled with bad debt, they can seriously for the next couple of years, they can grow at the pace they want to grow at. The large banks do not want to grow at more than 20-25 percent, but you can grow between 20 percent and 30 percent for the next couple of years in retail space reasonably well and NBFCs are benefitting from that. It is just a lack of availability of credit from a large chunk of the lenders in the system. And I do not think that changes.Q: Is there anything specific NBFC that you can speak about? For instance, I spoke about Bajaj Finance. It is already ruling at very tall valuations, where do they grow? How do they grow even bigger than this?A: We do not cover Bajaj Finance. Anyway, I cannot talk about individual stocks, but this one we do not cover. Q: But would you not think that there is a roof coming in simply because valuations have become too expensive.A: Again the question is, yes the multiples have gone up in most of these names, but as I said earlier, the compounding effect is so high, that even multiples start stabilising where we are, you essentially will generate a reasonably healthy return because earnings are compounding in high teens to 20 percent or so. That is not the case in financials anywhere in the world. You do not need to make a multiple expansion argument to be owning these.Q: Even if you do not have a multiple expansion argument, there is more competition coming in from the small banks. So, you will have the Equitas Holdings and the Ujjivan Financial Services lending and very soon, Bandhan Bank will join the bandwagon probably Janalaxmi Bank will list before we know. There is a big one Au Financiers, all of them might come in. So, do you not think there will be more choice for the investor and therefore, the microfinance company (MFC) game is very good, I am not denying that at all, it is wholesale money, but investors have more choice?A: At some point of time, because right now the thing about multiples is also because of as you said, lack of options. So, you have a few private banks, then you have the NBFCs and as more and more banks come in, people would say okay, should we look at the names you mentioned.The only thing there would be I would think that that part of the trade is two to three years away, because first of all, they need to start launching the bank business properly. They need to start growing, because right now, most of these guys are not growing, given that they are just becoming a bank and then investors will say okay let us see whether they are able to grow in a proper way without credit costs, etc. Till then, the non-banks should also be okay. If I take a 5-8 year view, yes that is a challenge. But next couple of years, they should be okay. I do not think they are competition.Q: Because there is a lot of money riding on those names at this point in time, especially on the expectation of good monsoon and therefore, rural financing also improving. Let me come to you on private lenders. Two corporate sectors. You have Axis Bank and YES Bank on your list. You cannot talk about names, but I can talk about names. Look at YES Bank for instance, its fourth quarter performance was an eye opener, in spite of its corporate lending. But it has gotten rewarded. It is like 30 percent higher or 25 percent higher in the last three months. Now is there not a valuation challenge?A: Let me not go into specific names, but private corporate sector as a whole, wherever investors have taken the view that asset quality is not that big a challenge, they have believed in the non-performing loans that the banks are reporting or they believe in the watch list which has been reported, people are looking forward and saying what will the earnings per share (EPS) look like in fiscal 2018 and fiscal 2019. And again, as I said, if you think about the growth which is going to come in, these stocks are not expansive. What may happen is obviously, these stocks have done very well. So, something has gone up 40 percent this year, can there be a pull back? Potentially, but if they keep reporting a 25-30 percent EPS growth number over the next 2-3 years, the shock will be on a relative basis, the stock should be doing very well. Next two to three months, I do not know, but from a 12-24 month perspective. These are the stocks you want to own.