The Financial Stability Report released by RBI in June 2016 indicated that the Gross Non-Performing Assets (GNPAs) of the Indian banking system may rise to 8.5% in March 2017 from 7.6% recorded in March 2016. The worst case scenario may take this figure upto 9.3% if the macroeconomic conditions worsen. In other words, this means out of Rs 100 lent, Rs 8.50 may not be recovered. This is a scary situation. Banks will have to buckle down and take serious measures to improve the asset quality. Unless this happens, the risk taking the ability of banks is unlikely to improve. This means banks can think about higher credit growth again only when they clear up the mess of bad loans on their balance sheets. Reading this, if you inferred that Indian banks may still be unattractive investment propositions, then be ready to receive a shock. And the Indian mutual fund industry will beg to differ.

Mutual funds are betting big on banks
As reported by Economic Times dated September 19, 2016, the industry collectively held a staggering investment of over Rs 1.05 lakh crore in banking stocks as on August 31, 2016. This accounts for 20.90% of the total equity Assets Under Management (AUM). In the Financial Year (FY) 2015-16, mutual funds were dumping banking stocks for reasons such as muted credit growth and a chronic problem of NPAs.
 

The outperformance of banking sector…

Data as on September 19, 2016
(Source: ACE MF, PersonalFN Research)

However, it seems the rally that started in the last week of February 2016 lured them to one of the most important sectors of Indian markets. The banking sector is believed to be a proxy for India's economic growth

Over the last 1 year, S&P BSE Bankex has generated 14.3% returns while S&P BSE Sensex has yielded 9.2% returns. Moreover, from the February-lows the S&P BSE Bankex has rallied ferociously, posting 48% gains whereas S&P BSE Sensex is up just 24.8% from the lows it made in February 2016. This might give you an idea about the appetite for banking stocks among investors.

A couple of months ago Harshendu Bindal, President, Franklin Templeton Asset Management (India) suggested that the worst might be over for the sector when in an interview to the media, he said, "We believe that bulk of the problem assets are recognised and gradually being provided for. Further, the transmission of rate cuts by the RBI especially on the lending rates is yet to get fully realised. Once that happens, banking stocks are likely to benefit." His views may not represent the views of other Asset Management Companies (AMCs), but there is every reason to believe that the mutual funds houses making significant allocations to banking stocks may not differ with him on this subject.

However, a few in the industry have a different view. Nilesh Shetty, Associate Fund Manager (Equity), at Quantum Mutual Fund stated that, "The sector has outperformed the benchmark Sensex by around 5 per cent. This could be the reason for the increase in the exposure."

Interestingly, Moody's, an independent credit rating agency of international repute, has predicted a "stable" outlook for the sector over next 1-1 ½ years' time. In its report, the agency expressed an optimistic view saying, "While the stock of impaired loans may still increase during the horizon of this outlook, the pace of new impaired loan formation should be lower than what it has been over the last few years."

Situation at the grassroots level...
Over recent months, banking stocks, especially those belonging to the Public Sector, have been buzzing on the back of some significant developments.

The loan repayment capability in the construction sector is expected to improve due to the steps taken by the Central Government to revive it. In the stressed assets of banks, the share of the construction industry has been high. The press release of the Cabinet Committee on Economic Affairs (CCEA) stated that "Under the proposal put forward by NITI Aayog and approved by the CCEA. Government agencies would pay 75% of the arbitral award amount to an escrow account against margin free bank guarantee, in those cases where the award is challenged. The escrow account can be used to repay bank loans or to meet commitments in ongoing projects. This is a major step which will allow recovery of loans by banks and allow construction companies to speed up execution of ongoing projects."

 

Some of the PSU banks have managed to generate huge treasury gains, thanks to a stupendous rally in Indian bonds. This has enabled them shore up their earnings at a time when credit growth is muted and provisioning for bad loans is still high.

Considering all positives and negatives mentioned above, it seems, we are standing at a very crucial juncture at this point in time. The banking stocks have witnessed an eye-popping rally over last the 6-7 months and valuations in this space, dearer now, given the challenging outlook. Like many experts in the industry along with mutual funds expect that the situation may not worsen further, but, recovery still appears to be a distant dream. Within the sector, not all banks stand at par with one another. Some of them are run extremely professionally and are growing at a decent pace even during turbulent times such as these, yet managing to maintain a good asset quality. However, the trouble is they are way too expensive on valuations. On the other hand, banking stocks that are available cheap are still shuddering with poor asset quality and struggling to grow, which raises doubts about the quality of management.

What investors should do?
Unless you have a flair for picking stocks rightly, you should avoid investing in banking stocks directly; for the simple reason that, there are no easy pickings. At the same time, you should also avoid investing in banking sector funds as any downtrend in the industry would spell bigger troubles for the investors, due to the concentrated nature of the portfolios of sector funds. Stock selection is a tough job, and you should leave it to the professional fund managers. If you want to take advantage of the potential recovery in the sector, then invest in an opportunities funds with a proven track record.

Ideally, invest in a fund that follows rigorous and time-tested investment and risk management processes. Best avoid a fund that speculates on the market momentum and has a speculative approach to stock picking.

If you are unsure about which funds to invest in, you may try unbiased mutual fund services offered by PersonalFN.

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