Fund Managers Are Betting Big on Financials: But Why Abandon Banks for NBFCs?

Foreign portfolio investors (FPIs) have shown inconsistent behavior when it comes to investing in financial and banking stocks, with buying sprees often interrupted by periods of selling.

After significant sales of shares of financial companies by FPIs in January and February, there was renewed interest in shares in March, only in April and May the sales resumed. This pattern continued with a brief buying spree in June followed by selling pressure in July and August.

On the domestic mutual fund front, the data shows a monthly increase in fund allocation to non-banking financial companies (NBFCs) and a decline in shares of private and public sector banks, according to a September report by Motilal Oswal Financial Services.

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

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

“Slowdown in credit growth, difficulty in deposit sourcing and net interest margin (NIM) compression are some of the key issues and this is one of the key reasons why we continue to maintain an underweight position in banks,” said Manish Jain, director, fund management at a company providing financial services Centrum.

However, he said this is not the case across the banking, financial services and insurance (BFSI) space.

NBFCs over banks: why this change?

Jain finds NBFCs operating in the mid-cap and small-cap segment very attractive and remains optimistic about the growth potential of housing finance companies, especially those focusing on affordable housing. “We selectively built positions in small financial banks. Hence, while we may not be optimistic about banks, the non-banking BFSI space still looks attractive.”

Banking stocks, which have long led the Nifty index, have fallen from their peaks recorded in July 2023, even after the completion of merger of HDFC Bank Ltd with its parent Housing Development Finance Corporation Ltd.

The share of financial stocks, which include banks and NBFCs, in the Nifty 50 has declined to 27.7% now from 32.0% in July 2023 and in the Nifty 500 to 18.5% from 23.2%. The main factor behind this decline is the poor performance of HDFC Bank, said investment firm PhillipCapital in a report dated September 24.

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Concerns have been raised over sluggish loan and deposit growth in the banking sector, strained loan-to-deposit ratios and deposit growth, especially with HDFC Bank’s loan-to-deposit ratio increasing to 104% at the end of March, higher than 85-88% during the summer budget 2020-21 to 2022-2023. HDFC is the largest private lender in India.

Meanwhile, the non-banking sector has gained importance over the past decade due to increased financial penetration and economic growth, PhillipCapital said, but added that it expects the financial space to gradually expand due to lower bond yields and anticipated interest rate cuts.

“NBFCs are gaining market share as banks adopt a more cautious approach in the current lending environment, which is reflected in their diverse growth trends,” Emkay Global Financial Services said in a report dated September 29 after a telephone conversation with Raoul Kapoor, CEO of Andromeda Marketing (India’s largest direct sales agent) and conversations with lenders and industry experts.

Emkay added that for banks, liquidity is an “irritant” beyond regulatory and asset quality issues. In turn, NBFCs are taking on increasing risks and aggressively expanding into non-traditional banking segments such as small and medium enterprise lending, low-cost housing finance and even high-cost bank-like personal loans, the financial services firm explained.

So where do the optimistic prospects for banks come from?

“The only reason for optimism among fund managers or investors when it comes to investing in the banking sector is value investing or contra strategy as the performance is weaker compared to broad market indices,” said Mayur Shah, fund manager providing portfolio management services at Anand Rathi Shares and Stock Brokers.

He explained that Indian private banks are more exposed to foreign institutional investors as FIIs hold significant stake in these lenders. Since the Indian market is valued higher than other emerging markets, if FIIs decide to shift their investments elsewhere, it could put additional pressure on Indian banks.

In addition, the loan-to-deposit ratio in the banking system is currently high, which means that banks are lending more than they earn through deposits. This makes it harder for banks to attract new deposits, which in turn limits their ability to expand lending and support credit growth, Shah said.

“On the other hand, the expected interest rate cuts by the end of the year will lead to a decline in NIM. Moreover, the quality of unsecured assets may further impact returns,” Shah said. Therefore, for now, the attitude towards the banking sector remains neutral, except for some who want to counterattack, he added.

NIM, or net interest margin, is a measure of a bank’s profitability. This is the difference between the interest a bank earns on 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 way to go to profitable growth, which positions them as potential strong company filers in the long term. In fact, what makes the financial sector even more attractive compared to other sectors is their relative underperformance recently, she said.

Strong monsoons, political stability, government’s emphasis on infrastructure creation, its ‘housing for all’ mission, projected increase in private capital spending, growing manufacturing activities in sectors such as electronic services and import substitution products, India’s credit growth will be widespread in the coming months, Agrawal said. “So height is not an issue.”

India’s interest rate cut cycle is expected to take place in March this financial year. The consensus is that the Reserve Bank of India will make a modest, symbolic cut rather than a sharp one. While the immediate impact of the rate cut would likely lead to margin compression, Agrawal believes it will not be severe, although the effects will still be visible in this quarter.

The Centre’s Jain does not believe that the RBI will cut the policy rate this calendar year. “When this happens, hopefully by the first quarter of the next calendar year (March quarter), NBFCs will be in a much better position compared to banks to cope with the rate cut cycle.”

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