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Let me start this post with review on our previous sector. After first quarter results of Maruti Suzuki, we still expect its earnings to be Rs 102 per share and that translates its intrinsic value for 2014 to be Rs 915 and 2015 to be Rs 1,221. It is still trading at premium price.

Banking sector is considered as a backbone of any economy. From last one year we have witnessed a lot of volatility in the share prices of the bank, especially the public sector banks.

Let us try to understand this business and see if there is any opportunity available to invest with them.

Most of the Indian banks offer same commoditised products including every day banking, loans, credit cards, wealth management and insurance products. Because of this it is easy to compare the financial statements and metrics.

In simple terms, Indian banks generate its revenues via two main sources. The primary source is their lending activity (or loan books), on which they make ‘margin’. Also known as Net interest margin, this simply refers to the difference between their cost of borrowings from savers (depositors) and other funding sources, and the price of the loan. In Indian markets we have seen these margins in range of 2-3% when compared to the bank’s asset base.

Let’s take example of HDFC bank, the total bank’s asset base for 2013 was Rs 407,722.98 crore rupees and they earned net interest Rs 16, 165.57 crore. That turns out to be 3.96% which is very healthy returns compare to other Indian Banks.


Assets

 

Cash & Balances with RBI

14,630.88

14,991.63

Balance with Banks, Money at Call

12,900.28

6,183.53

Advances

247,245.12

198,837.53

Investments

110,960.41

96,795.11

Gross Block

6,555.63

6,024.90

Accumulated Depreciation

3,782.32

3,646.99

Net Block

2,773.31

2,377.91

Capital Work In Progress

0

0

Other Assets

19,212.98

20,403.96

Total Assets

407,722.98

339,589.67

The second source of income, which can offer a revenue return of 1% – 2% on assets in a good year, comes from the proprietary trading and services as insurance and wealth management services. In combination, a well performing bank will generate about 3 -5% returns on their total assets.

In HDFC banks example, its other income had given a return of 1.75%, and in aggregate a return of 5.71% on its asset base.

Income

 

Interest Earned

35,861.02

27,605.56

Other Income

7,132.96

5,646.07

Total Income

42,993.98

33,251.63

Let’s look at the table of other banks performance for 2013 on the above discussion:

Name

NIM

Other Income

Total returns on Asset

Allahabad Bank

2.39%

0.76%

3.15%

Axis Bank

2.84%

2.01%

4.85%

Canara Bank

1.88%

0.79%

2.67%

DCB

2.52%

1.04%

3.56%

HDFC Bank

3.96%

1.75%

5.71%

ICICI Bank

2.46%

4.34%

6.80%

Indian overseas bank

2.15%

0.81%

2.96%

Indusind bank

3.05%

1.86%

4.91%

J&K Bank

3.23%

0.68%

3.91%

Kotak Mahindra bank

4.16%

4.41%

8.57%

OBC

2.34%

0.82%

3.16%

South Indian Bank

2.57%

0.67%

3.24%

SBBJ

2.98%

0.84%

3.82%

SBI

2.87%

1.53%

4.40%

Like any other businesses, there are cost associated to their revenues. In banking business almost 50% of revenues are chewed up by operating expenses. If we pull out the cost from its revenues then the total returns on asset will look like this:

Name

Returns on Asset

Cost to Income

Net Returns on Asset after operating cost

Allahabad Bank

3.15%

1.51%

1.64%

Axis Bank

4.85%

2.09%

2.76%

Canara Bank

2.67%

1.23%

1.44%

DCB

3.56%

2.67%

0.89%

HDFC Bank

5.71%

2.86%

2.86%

ICICI Bank

6.80%

4.49%

2.31%

Indian overseas bank

2.96%

1.39%

1.57%

Indusind bank

4.91%

2.41%

2.50%

J&K Bank

3.91%

1.37%

2.54%

Kotak Mahindra bank

8.57%

5.66%

2.91%

OBC

3.16%

1.33%

1.83%

South Indian Bank

3.24%

1.52%

1.72%

SBBJ

3.82%

1.83%

1.99%

SBI

4.40%

2.46%

1.94%

After removing the operating cost, the only other thing you can think about is the bad loans. As banks are in lending business they also face risk of defaults. They normally keep a provisions of 1 – 2% on their loan books.

If we do an acid test and assume that these banks face those defaults then their returns will be as follows.

Name

Returns on Asset after operating cost

Expected % defaults on total assets

Net Returns after  Default provisions

Allahabad Bank

1.64%

1.07%

0.57%

Axis Bank

2.76%

1.21%

1.55%

Canara Bank

1.44%

0.75%

0.69%

DCB

0.89%

0%

0.89%

HDFC Bank

2.86%

1.21%

1.65%

ICICI Bank

2.31%

0.83%

1.48%

Indian overseas bank

1.57%

1.31%

0.26%

Indusind bank

2.50%

1.09%

1.41%

J&K Bank

2.54%

1.04%

1.50%

Kotak Mahindra bank

2.91%

0.97%

1.94%

OBC

1.83%

1.16%

0.67%

South Indian Bank

1.72%

0.70%

1.02%

SBBJ

1.99%

1.14%

0.85%

SBI

1.94%

1.04%

0.90%

Banking business is the most leveraged business listed on the stock market. If 2% -3% loan book becomes sour then you lose the whole years profits. This is the reason they are very sensitive to prices. The best banks are the one who has one of the best risk management process while lending the money and are working towards growing their proprietary business to cushion if any worse case scenario arises from lending business.

At the moment we would prefer businesses that are generating at least 1% return on total asset and also are expected to grow their earnings more than 10% for next year.

We come up with the following names:

Name

Net Returns after  Defaults

Earnings growth expected by VO

Earnings growth expected by consensus

Axis Bank

1.55%

17%

15%

HDFC Bank

1.65%

30%

23%

ICICI Bank

1.48%

13%

0%

Indusind bank

1.41%

16%

22%

J&K Bank

1.50%

16%

7%

Kotak Mahindra bank

1.94%

23%

16%

It is amazing to see that only private sector banks got qualified so far. We did filtered out one of the best businesses so far from this basket, but would be smarter only if we invest in the businesses that are trading at cheap.

The following table will explain which one is trading at discount.

Name

IV for 2014 VO

IV for 2015 VO

IV for 2014 Consensus

IV for 2015 Consensus

Axis Bank

Rs 1,273

Rs 1,496

Rs 1,238

Rs 1,601

HDFC Bank

Rs 434

Rs 609

Rs 395

Rs 555

ICICI Bank

Rs 820

Rs 916

Rs 680

Rs 882

Indusind bank

Rs 242

Rs 301

Rs 245

Rs 348

J&K Bank

Rs 2,543

Rs 2,882

Rs 2,255

Rs 2,702

Kotak Mahindra bank

Rs 350

Rs 446

Rs 318

Rs 421

Mind you these intrinsic values are not calculated after acid test (they are calculated assuming they won’t face defaults).

The market is throwing out 2 businesses from the above list for the discount at the moment. They are Axis bank and J&K bank.  I will be sharing few more stats in my next post on the banking. Do let me know if you want me to add your banks in the list.  Finally, we do own Axis bank and J&K Bank in our portfolio. We also own very few shares of SBBJ.

Please also pursue banks with best financial metrics, the brightest prospects, and if you buy them below assessed intrinsic values you should be rewarded on time.