Banking -move towards safer heavens; Avoid mid cap PSU banks: Edelweiss

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Maintaining our long term fundamental positive view on banks, we believe emerging near term headwinds (largely macro in nature) warrant a closer look, given  the strong outperformance (of 11%) of banking stocks over the past six months (despite the 5% fall over the past three days). We believe the Street, currently, is grappling with the following concerns surrounding the banking sector:

1.    The recent fallout of the CBI inquiry 

2.    A classic RBI dilemma: A sticky inflation coupled with moderate growth

3.    Can we miss credit growth targets?

4.    Are best of margins behind us?

5.    Is there a risk to systemic liquidity

6.    Is the pain of asset quality really behind us?

7.    Can pension cost throw a negative surprise?

1) While the recent fallout of CBI investigation will adversely impact sentiments, it is unlikely to have a material impact on financials given the amount/companies involved and secured exposures. 2) The headwinds on commodity prices, coupled with out of turn rainfalls, have the potential to keep inflation above the RBI target range of 5.5% by FY11. However, the modest IIP readings put the central bank in a spot to tighten further. 3) The credit growth momentum build up so far suggests that we are on track to achieve atleast 20% credit growth despite risk emerging from disintermediation via offshore money and IIP growth decelerating. 4) Margins have peaked in Q2FY11; however, they have set at much higher than anticipated levels. 5) The current liquidity tightness in the market is not systemic and clearly reflects the timing mismatch between outflow to government and inflow into the system via government spending. 6) While MFI exposure, 2G license fees and bribery cases can put a brake on some of the players concerned, from a systemic perspective they cannot derail the asset quality improvement story. 7) Second pension option liabilities and gratuity cost could result into higher-than-expected cost pressure in the near term; however, opex/asset will still continue to trend down marginally supporting ROA.

n  Outlook: Move to safer heavens

We believe the ongoing environment exhibits a classic battle between fundamental impact and perception impact—the reaction on banking stocks will be biased towards sentiments derailing the re-rating story for public sector banks. We once again re-iterate that we are fundamentally positive on banks and believe earnings progression will be strong led by core performance—sector earnings to post 27% CAGR over FY10-12E–with private sector taking a lead with 31%. In this environment of uncertainty and macro headwinds we would recommend investors to skew their position more towards safer havens. Our pecking order suggests a move towards quality bets where valuation comfort is high:

1.    High quality private banks: HDFC Bank, ICICI Bank

2.    Mid cap private banks : Yes Bank, Federal Bank

3.    Large cap PSU banks: Bank of Baroda, Union Bank

4.    Avoid mid cap PSU banks