The RBI has given indication that interest rates have peaked out and necessary rate cuts would surely take place as and when crude oil price stabilizes and threat to high inflation eases. In view of this, what should an investor do regarding banking stocks? Which stock should be picked and which one should be sold off? 

Banking sector has been facing various challenges like tight liquidity, slower growth of credit and deteriorating asset quality. At the moment, cost of funds is on higher side for the banks and because of the higher interest rates non-food credit growth is low which is affecting the Net Interest Margins. Moreover with current higher interest rate regime, there is a fear of further rise in restructured assets and more loans falling into NPA category. There are concerns of rising NPAs due to slowdown in industrial growth. Global economic slowdown is another probable worry for the sector.       

But inflation has been the single biggest overhang on banking stocks over the last 12 months. In FY2012, average inflation has been close to 8.2-8.5 per cent, so even if it averages about 6-6.5 per cent in FY2013, this will be a big improvement over FY2012. As a result, RBI is expected to ease monetary policy and broader interest rates are also expected to cool down by about 100-150 bps. Additionally, capital infusion would support PSU banks for further business expansion.

Now, with inflation starting to cool down, certainly there are various positive factors which are likely to prove better for banking stocks.

Impact of unchanged interest rates

The monetary policy on March 15 was on expected lines. No one was expecting a rate cut in this policy. Hardly a few days back, the RBI had cut CRR by 75 bps. Inflation is clearly lower than it was a few months back and the RBI is taking cognizance of that, so its overall stance is clearly dovish rather than hawkish. With OMOs (open market operations) of Rs 1.2 lakh crores and cutting CRR by 125 bps already (infusing Rs 80,000 crores), it made sense for the RBI to wait for some time before cutting rates. The RBI has given indication that interest rates have peaked out and necessary rate cuts would surely take place as and when crude oil price stabilizes and threat to high inflation eases.

So what do these all mean for banking stocks? Madhumita Ghosh, Senior Vice President- PMS & Research, Wealth Management, Unicon Financial Intermediaries, says, “The unchanged interest rate is negative for the banking stocks for short term as expectations were built around it. However, for medium to long term it is better for the economy as the inflation facing challenges from higher crude price is still not in the comfortable zone.”

Vaibhav Agrawal, VP Research- Banking, Angel Broking, says, “By April, they may have inflation and IIP reading as well as a clear idea of the fiscal deficit, so in our view that's when they would go ahead with a rate cut, provided inflation continues on the moderate trajectory that we are expecting in the coming months.”

What should an investor do?

At this juncture, the million dollar question is—what should an investor do regarding banking stocks looking at all these factors? Saurabh Jain, Associate Vice President - Research (Equity), SMC Global Securities, says, “I think the overall growth in the banking business would remain in the range of 14-15 per cent in comparison to 18-19 per cent in the previous years because of higher interest rates. The fear of rise in delinquency rates and more restructured assets would continue to pose risks from the investment point of view in the banking stocks.”

On the other hand, Agrawal says, “Valuations for bank stocks remain reasonable even after the recent rally. So, we maintain a positive view on the banking sector. Within the banking space, we continue to like private banks. In our view the earnings outlook for the larger private banks remains reasonably good. Also, the relatively better under-writing standards at the private banks are so far getting borne out in the past couple of result seasons.”

Despite his concerns, Jain favors taking a call in banking stocks at this juncture as he says, “The banking stocks especially some of the mid cap banks are actually trading at low multiples if one compares with the valuation a year before. Despite some of the risks mentioned, if one takes a call on the banking stocks with two-three year kind of a horizon then he would be able to get at least 50 per cent return from here.”

Now the question is—which are the stocks from the sector to be picked? Ghosh says, “Investors can start accumulating the banking stocks at current valuations and every decline. We recommend YES Bank, Allahabad Bank & Development Credit Bank along with some of the large cap banks like SBI, ICICI bank at the current valuation. We see a minimum upside of 20 per cent in SBI, ICICI Bank, Axis Bank and HDFC Bank from a 12 to 18 month horizon.”

Adds Jain, “Stocks like Dena Bank, Allahabad bank and Indian Bank are quite interesting and one can accumulate them at lower levels. From the short term and long term perspective, private banks like Axis Bank, ICICI Bank, HDFC Bank are good to invest but the valuations are not so cheap. SBI in particular is doing well.”

State Bank of India

SBI is in process of cleaning up its balance sheet with focus on NPA recovery. Agrawal says, “Considering the bank's dominant position and reach, strong savings market share gains, high fee income and superior earnings quality and recent impressive performances on margin front, we recommend an Accumulate on the stock with a target price of Rs 2,587.”

ICICI bank

ICICI bank is expected to continue to deliver a steady performance while maintaining a balance sheet growth with profitability and stable asset quality. The revenue increase will be driven by growth in NII and fee income growth. Things are looking better for the bank, owing to its attractive CASA franchise, rapid branch expansion, multiple sources of sustainable fee income and strong growth outlook.

Agrawal says, “We believe the bank is decisively executing a strategy of consolidation, which has resulted in an improved deposit and loan mix and should drive improved operating metrics over the medium term. We maintain our Buy rating on the stock with a TP of Rs 1,193.”

HDFC Bank

HDFC Bank is expected to keep around 24 per cent of credit growth and also expected to maintain the CASA ratio at around 48 per cent.

On the back of continuous growth momentum, strong business and credit growth, improvement in asset quality and strong capital adequacy, HDFC bank commands a premium in its valuations. Ghosh says, “We remain positive on the bank.”

Axis Bank

Axis Bank is targeting a credit growth of around25 per cent in FY13 on back of branch expansion. Also the cost-income ratio is expected to gradually move up to 44-45 per cent. NIMs are likely to fall marginally on back of rising costs.

Agrawal says, “We remain positive on the bank, owing to its attractive CASA franchise, rapid branch expansion, multiple sources of sustainable fee income, strong growth outlook and A-list management. We continue to maintain our Buy view on the stock with a target price of Rs 1,671. Axis Bank is one of our top picks in the sector.”