With economic growth slipping to a four-year low and interest rates close to previous highs at 9 per cent, have banking stocks — that boast of a direct correlation to the economic and rate cycle – bottomed out? Is it the right time to play the recovery riding on these stocks?

Birla Sun Life Banking and Financial Services fund, a new fund launched last week, seems to think so. It is banking on the economic recovery and places its bets on the one sector that can outperform in such a case.

why stocks fell

Till January this year, bank stocks were hot picks, as investors were betting on rate cuts and a possible economic recovery. The CNX Finance and the BSE Bankex were up over 20 per cent between September 2012 to January this year. But the RBI’s liquidity tightening measures in July to arrest the steep fall in the rupee proved a dampener.

Short-term interest rates went up. Longer term rates also inched up as the RBI increased rates to control inflation. Growth expectations moderated, from 5.7 per cent to around 4.5 per cent for 2013-14. Banks grappled with slowing loan growth, lower deposit mobilisation, pressure on margins and rising bad loans. From June to August this year, the CNX Finance index declined sharply by 25 per cent.

Signs of recovery

But the sector has seen some respite since September. For one, short-term interest rates that spiked have normalised and banks have been able to bring down their short-term borrowing costs. Two, the liquidity situation has vastly improved, easing up the margin pressure on banks as well as improving the accessibility of funds for borrowers. Three, while policy rates were hiked twice since September, there is more clarity on how interest rates will pan out in the next 12-18 months.

Select with care

So while the going remains tough for the sector, it also provides good opportunity for investors to gain significantly once the economy turns around. Loan growth has been 2.5-3 times the real GDP growth in the past.

Within the banking space, though, there’s a divergence in performance of public and private sector banks. Private sector banks posted healthy loan growth, stable margins and good asset quality in the recent September quarter, which has been one of the most challenging and volatile quarters.

While public sector banks may appear attractive from a valuation perspective, their troubles with non-performing loans weigh on prospects. They have higher exposure to stressed sectors such as infrastructure, power and roads than their private counterparts. Recent reforms in these sectors could, however, restart project execution and improve outlook.

Picking the right stocks within the banking space is therefore crucial.

Fund strategy

Birla Sun Life has indicated that its Banking and Financial Services fund portfolio will be tilted towards private banks, and staying with banks which have lesser risk and higher growth potential. Select public sector banks that do not run the risk of huge erosion in their book due to capital infusion will be preferred. The fund will also look at non-banking financial services that have managed to grow at a healthy pace. Similarly, credit rating agencies may also find a place within the portfolio.

The fund is benchmarked against the CNX Finance, which is highly skewed in favour of a few stocks — over 60 per cent comprises three stocks: HDFC, HDFC bank and ICICI Bank. Thus, it offers enough room to outperform the index by diversifying the portfolio, including smaller- and higher-growth banks within the private sector space.

The fund will be managed by Mahesh Patil. He manages other funds such as Birla Sun Life Top 100, Birla Sun Life Long Term Advantage, Birla Sun Life Frontline Equity and Birla Sun Life Infrastructure. Barring the Infrastructure fund, all others have beaten their benchmarks consistently and are top-quartile funds in their respective categories.

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