Can The Small PSU Bank Share Rally Endure?

The Bank Nifty index has experienced a modest 3 per cent increase over the past two years, with notable differences in the stock prices of large and small banks within its constituents. Analysing factors such as returns, operating performance, credit cycle, NPA movement and provisioning trajectory, we explore whether the outperformance of smaller Public Sector Banks (PSBs) compared to large banks can be sustained.

Business Performance Insights: Smaller PSBs witnessed a decline in market shares (deposits + advances) in FY23 relative to both State Bank of India (SBI) and larger Private Sector Banks (PVBs). However, the recovery of written-off loans boosted return ratios for PSBs. Large private banks maintained gains in business shares, credit cycle and demonstrated better underwriting records in FY23. RoEs of PSBs saw a significant rise in FY23, while those of PVBs experienced more moderate increases.

Market Reactions: Smaller PSBs saw substantial increases in stock prices and valuations, particularly in the last 8-12 months. Bank of Baroda's valuations benefited from declining NPAs, while valuations of PVBs moderated despite their relatively better credit cycles. Major banks, including SBI and large private banks, witnessed de-rating during this period.

Potential Sustainability: The valuation disparity for smaller PSBs appears to be driven by RoE gains rather than fundamental business cycle factors. The recent re-rating of smaller PSBs is attributed to RoE gains from the recovery of written-off loans, contributing disproportionately to net profits. However, these factors are considered legacy and their impact is expected to decline.

Smaller PSBs at Peak Valuations: The concentrated bets of certain Foreign Institutional Investors (FIIs) and factors like the recovery of written-off loans have led to higher return ratios and valuations for smaller PSBs. Changes in shareholding patterns have influenced these valuations. The surge in other income, a key driver of superior RoE for smaller PSBs, may be transient, potentially leading to a derating of their valuations.

Larger Banks' Potential Outperformance: Evolving cyclical factors, including global rate tightness, FII outflows, rising yield curves, pressure on Net Interest Margins (NIMs) and the bottoming out of the NPA cycle, will likely determine the performance of banks and Non-Banking Financial Companies (NBFCs). Larger banks with better Asset and Liability Management (ALM) positions and underwriting capabilities are expected to outperform.

Overall Sector Position: Maintaining an underweight position for the Banking, Financial Services, and Insurance (BFSI) sector, we anticipate that larger banks will exhibit resilience in the face of evolving market dynamics.