Fund managers bet big on financials: But why ditch banks for NBFCs?

Foreign portfolio investors (FPIs) have shown erratic behaviour when it comes to investing in finance and banking stocks, with buying sprees frequently interrupted by periods of selling.

After significant selling of financial stocks by FPIs in January and February, March saw renewed interest, only for the selling to resume in April and May. The pattern continued with a brief buying spree in June, followed by selling pressure in July and August.

As for domestic mutual funds, data reveals a month-on-month increase in fund allocation for non-banking financial companies (NBFCs) and a decline for private and public sector bank stocks, according to a report by Motilal Oswal Financial Services in September.

Notably, the weight of private banks in mutual fund allocations hit a nearly six-year low of 15.9% in August, down 20 basis points from the month before and 330 basis points from a year earlier.

Meanwhile, over the past three months, the Nifty Bank index gained only about 1% and the Nifty Private Bank index 1.5%, significantly lagging the Nifty 50’s 7% surge in the same period.

“Slowing credit growth, difficulty in raising deposits, and net interest margin (NIM) compression are some key issues, and that is one of the key reasons why we continue to maintain an underweight position in banks," said Manish Jain, head-fund management, at financial services firm Centrum.

He, however, said this does not hold true for the entire banking, financial services, and insurance (BFSI) space.

NBFCs over banks: Why the shift?

Jain finds NBFCs in the mid- and small-cap space very attractive, and remains optimistic about the growth potential for housing finance companies, particularly those focused on affordable housing. “Selectively, we have been building positions in small finance banks. Hence, while we may not be optimistic on banks, the non-banks BFSI space continues to look attractive."

Bank stocks, which have long led the Nifty index, have slipped from their peak weights seen in July 2023, even after HDFC Bank Ltd completed its merger with its parent Housing Development Finance Corporation Ltd.

The weight of financial stocks, which include banks and NBFCs, in the Nifty 50 dropped to 27.7% currently from 32.0% in July 2023, and in the Nifty 500 to 18.5% from 23.2%. The primary factor behind this decline is HDFC Bank’s underperformance, investment firm PhillipCapital said in a report dated 24 September.

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There have been concerns over the banking sector’s slow loan growth, stretched credit-deposit ratios, and deposit growth, particularly with HDFC Bank’s credit-deposit ratio rising up to 104% as at the end of March, higher than the 85-88% during fiscal years 2020-21 to 2022-2023. HDFC is India’s largest private lender.

Meanwhile, the non-bank sector has gained prominence over the past decade due to increased financial penetration and economic growth, PhillipCapital said, but added that it expects a gradual build-up in the financials space given lower bond yields and anticipated rate cuts.

“NBFCs are gaining market share as banks are adopting a more cautious approach in the current lending environment, which is reflecting in their diverse growth trends," Emkay Global Financial Services said in a report on 29 September after a call with Raoul Kapoor, chief executive officer of Andromeda Marketing (India’s largest direct selling agent), and discussions with lenders and industry experts.

For banks, liquidity has been “an irritant" beyond the regulatory and asset quality concerns, Emkay added. In contrast, NBFCs have become more risk-taking and are aggressively expanding into non-traditional banking segments such as lending to small and medium enterprises, affordable housing finance, and even high-ticket personal loans similar to banks, the financial services firm explained.

So why the bullish outlook for banks?

“The only reason for optimism by fund managers or investors to invest in the banking sector is a value investment or contra strategy as there is underperformance compared to broad market indices," said Mayur Shah, portfolio management service fund manager, Anand Rathi Shares and Stock Brokers.

He explained that Indian private banks are more exposed to foreign institutional investor activity because FIIs hold a significant share in these lenders. Since the Indian market is valued higher than other emerging markets, if FIIs decide to move their investments elsewhere, it could put extra pressure on Indian banks.

Also, the loan-to-deposit ratio is currently high in the banking system, meaning banks are lending more than they are bringing in through deposits. This makes it difficult for banks to attract new deposits, which in turn limits their ability to increase lending and support credit growth, Shah said.

“On the other hand, anticipated interest rate cuts by the end of the year will lead to contraction in NIMs. Also, unsecured asset quality can further impact the earnings," Shah said. Hence, for the time being, the view for the banking sector remains neutral, except for some who want to take a contra bet, he added.

NIM, or net interest margin, is a measure of how profitable a bank is. It is the difference between the interest a bank earns from loans and mortgages and the interest it pays to depositors.

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Trupti Agrawal, fund manager at WhiteOak Capital AMC, said financial companies have a long runway for profitable growth, positioning them as potential strong compounders over the long term. In fact, what makes financials even more attractive compared to other sectors is their recent relative underperformance, she said.

With strong monsoons, political stability, the government’s thrust on infrastructure creation, its housing-for-all mission, an anticipated rise in private capital expenditure, growing manufacturing activity in sectors like electronic services, and import substitution products, India’s credit growth will be broadbased in the coming months, said Agrawal. “So, growth is not a concern."

A rate cut cycle in India is expected by the March quarter of this fiscal year. The consensus is that the Reserve Bank of India will implement a modest, symbolic cut rather than a sharp reduction. While the immediate impact of the rate cut would likely lead to margin compression, Agrawal believes it won’t be severe, though the effects would still be evident in that quarter.

Jain of Centrum does not think that RBI will cut its key policy rate this calendar year. “As and when it does, hopefully by the first quarter of next calendar year (March quarter), NBFCs will be in a much better position as compared to banks to deal with the cut cycle."

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