Thursday, October 3, 2013

Banking Stocks- A parallax view- An old article revisited

BANKING STOCKS When we invest in stocks, we are betting on the premise that we will be able to sell it to someone else at a price. This is the liquidity that stock exchanges provide. We make many assumptions in arriving at what price we are willing to pay. All of these basically boil down to what money (earnings) the company will make from its business. The other big investor (the promoter) also theoretically gets the same benefits, apart from other non financial benefits that may come his way. I am not talking about any money he may make other than the legitimate dividends and the management compensation he gets. His wealth is represented by his share in the market capitalization of the company. For the promoter, the company is a real asset and he is at full liberty to deal with the profits of the company. He can pay dividends, buy assets or simply keep cash. He can use funds from one company to promote another. In short, he is the absolute master of all the assets of the company. He has a high level of motivation in keeping the company as profitable as he can. The promoter also wants to own as much of the company as he can and he also has the freedom to take the company private by buying out all the shareholders.

Other investors have the confidence that whatever happens to the shares held by the owner, the same fate awaits them. The promoter, within the framework of law, is the absolute master of the company. I wonder whether this premise can be applied to someone who sets up a commercial bank. A bank is not at all like other industries in respect of ownership. In fact, being an owner of a bank is very demanding and legally complex. Firstly, the Central Bank (RBI) puts a limit on the ownership in a Bank. The main promoter cannot have a clear majority. The day to day functioning, the deployment of the bank’s assets etc all are subjected to guidelines laid down by law. If the promoter has other industries, a bank owned by him cannot lend monies to it.

The profits that a bank makes cannot be disposed at will. Dividend payments have to be approved by the regulator. The regulations cover virtually every aspect, including the remuneration that a CEO can draw. The promoter cannot use the bank’s money to do any single act that is not permitted by the regulator. And there are not many things that are permitted. A bank cannot promote a company n another industry. A banker cannot promote a car manufacturing business. Of course, instances abound of shady promoters who have bent the law to have higher ownership apart from diverting loans to friends and family. But these cannot be a goal on which one would like to buy shares in a bank as an investor. And of course, we have businessmen who have ‘used’ a bank to push business in other financial services like mutual funds, stock broking or wealth management. They have used banking clout to build and strengthen other businesses. However, in this, the bank shareholders may not be participants.

To my mind, a bank is very much like a mutual fund. A mutual fund invests in shares and bonds of different companies and the unit value is computed every day. No one will ever pay a ‘premium’ to the NAV of a mutual fund. If I extend the same logic, a bank takes money from various people and lends it to different people for a fixed return. There is no upside on what it lends. If it lends a rupee, it will not get back anything more than a rupee. The book value of the share of a bank represents the value of all its assets (loans) less its liabilities (deposits, borrowings etc). The only difference between the mutual fund and the bank is the fact that a bank has ‘capital’ that is provided by the shareholders. In a mutual fund, there is no such thing.

The argument is that a bank’s profits grow. So does the NAV of a mutual fund (the debt part surely). A bank has to provide for assets that are stressed. A mutual fund NAV rises or dips as per the market prices. So, if we are paying three times or five times the book value of a share of a bank, is it solely on account of the incremental profits that we expect the bank to show? And these profits are not available for disposal, except in liquidation. No bank will voluntarily liquidate when the going is good. When it liquidates, it is generally because it has blown away all the money in poor lending.

An owner of any business can sell off the business to anyone at any point in time. A bank cannot do that. It can at best merge or sell itself to another bank. Again, we come to who can take the call. Typically, someone with no personal stake in the bank will take the call if it is ‘professionally’ managed or a PSU. Or someone who takes a decision would have reasons beyond the balance sheet to make the corporate event happen. All in all, buying or selling a bank is a cumbersome process and not very exciting.

So why do we buy bank shares? And why do we pay so much? Of course, one can argue that when it comes to PSU Banks, we are already paying close to or less than the book values. However, here we do not know the true book value since there is a debate on what the actual quantum of bad debts are and they have liabilities like employee pensions that have not been fully provided for. On the other hand, we seem to go to extremes, paying several times book value for stocks of private banks, expecting thirty percent plus growth in perpetuity.

However, the world believes in bank stocks. For markets like ours, the wise men tell me that banking will lead economic growth. So, much so that we have created structures like ETF for Banking Stocks, to bend the rules laid down by RBI about foreign ownership levels in banks. Not too long ago, we saw a ‘premium’ on foreign shareholding part of SBI!!

In a way, if we have to find out a basis for investing in bank stocks, I would recommend using what I would call as growth in book value. In essence it means paying attention to the profitability after all provisioning. The sad part is that banks continually need capital and each dividend they pay only compounds the problem. Dividends also go on to reduce the book value. The key would be to take a call on a price relative to its book value. That in turn would be dependent on its profitability (Return on Equity) and the expected rate of growth in the profits. It is not very complex to figure out. Of course, the interesting thing is when we start adding in the factor of belief or disbelief in the quality of the assets that a bank has. This is clearly the factor that is responsible for the very high valuations accorded to the private sector banks relative to the PSU Banks. If I go back in time and look at relative valuations of, say 2008 (after the Lehman crisis), the credibility gap seems to have widened even more, with private banks’ stocks being valued even more richly on the basis of reported numbers.

Going by the faith that the markets seem to repose in private banks, one small accident can derail the entire cart. PSU bank stocks have not been trusted too much so their valuations are unlikely to drop as steeply, should there be a crisis in the banking industry. Private sector bank stocks have to meet the very high expectations that investors are reposing in them. The stock prices of private sector banks have risen far more than the change in their book values. In case of PSU banks, the price rises have been far lower, implying a lack of confidence in the numbers. Whilst I do not advocate investing in stocks of PSU Banks, investing in private sector banks at this stage, is unlikely to fetch very high returns.

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