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Portfolio Commentary

Dec 22, 2022

Taking stock of the top theme in Sanctum Indian Titans (Titans)
The Indian headline indices hit a new high in the month gone by, which is a tall feat given the major world markets are yet to recoup their losses from the current turmoil meaningfully. The divergent performance of the Indian markets was largely due to heavy lifting by the entire gamut of banking stocks and a recovery in the IT names from their September lows.

In our communications at the start of the year, we highlighted our bullish view on a few broad themes, including housing, financials and manufacturing. As the year ends, we decided to revisit the performance of the top portfolio theme – Financials.

Below is the theme distribution of the Titans portfolio, which hasn’t changed meaningfully in the last twelve months.

Credit growth marching on
The Indian headline indices hit a new high in the month gone by, which is a tall feat given the major worldWe were positive on the lending companies as we believed that the loan growth – which was already under pressure pre-COVID – would return after the COVID-accentuated lull.

Though the pickup in credit growth was already underway before the year started, it picked up significantly as the year progressed, as seen in the chart below. The latest fortnightly print on credit growth came in at 17.2%, led by retail demand and increased corporate loans. The growth was also driven by the banks’ ability to disburse new loans now due to adequately capitalized bank balance sheets, deleveraged corporate balance sheets and adequate provisioning.

The aggregate loan growth in the Titans portfolio stocks also ticked up 12% H1FY23. An interesting point to note is that the lenders in the Titans portfolio grew much better than the industry, even in slower credit growth periods, while maintaining decent asset quality (details below), which is a testament to the prudent lending practices these lenders follow.

Asset quality issues receding
While the credit growth picking up is a big positive, a major reason for the underperformance of the lenders was the asset quality issues that surfaced post the asset quality review (AQR) done by the RBI in 2015. As the provisions and write-offs peaked in 2018 and started declining in 2019, COVID struck the economy, and the banking stress ballooned again, leading to continued pressure on credit costs.

The asset quality, after these setbacks, has now improved significantly from the trough, as seen in the chart below. Though the stress is at a multi-year low, the overall asset quality still looks weak compared to the FY12 levels. The numbers from FY12 may not be strictly comparable as several banks resorted to evergreening of loans in the pre AQR era. That said, the asset quality now is within the manageable threshold and is not as much of a concern, which gives confidence to banks to lend.

The Titans-portfolio lenders have a much better asset quality than the entire lending universe. Even in the high-stress period of FY17-FY20, these lenders maintained a significantly better asset quality, which helped them wither the economic slowdown and the COVID shock with relative ease.

Earnings significantly above the pre AQR era
The earnings of the lenders have also picked up significantly, surpassing the pre-AQR aggregate profitability in FY21. The profits further hit a new high in FY22, as shown in the chart below. The H1FY23 performance is also looking robust, with a 51% growth in overall profitability and a 67% growth in profitability of private lenders. The lenders in Titans portfolio achieved a 35% YoY growth in H1FY21.

The pickup in earnings has largely been led by growth in private lenders’ profitability on the back of rising loan books and stable margins. Provision reversals and writebacks also aided the profitability in FY22. For PSU lenders, reduction in credit costs has been the key driver of profitability growth. As the major impact of provision reversals and writebacks from AQR and COVID stress is over now, the growth hereon will largely depend on credit growth and market share gains.

The lenders in the Titans portfolio stand to gain in the current times as these are top-notch franchises with high ROEs. Even in the tough period of 2017-2018, the earnings of the lenders in Titans portfolio did not suffer a big blow and recovered quite quickly. As the normalization impact of bad credit cycle gets over, the risk-adjusted earnings growth would look better in these lenders.

That’s not it
Apart from the robust system credit growth and high profitability, the Indian lenders have the highest ever capital adequacy, return-on-assets (ROAs) and return-on-equity (ROE), and a domestic facing business, shielding them from global uncertainties.

In Titans, we have consciously chosen the frontline banking stocks and NBFCs, that have a much better ROE profile than the overall universe. The better ROE profile results in higher valuation multiples for these lenders, which in turn helps these lenders attract cheap capital. Also, as lending is a risky business, we have limited our exposure to lenders which have astutely managed their risk in the past or have seen a marked improvement in their risk management practices off late.

The table below shows the average ROE comparisons of the lending universe with lenders in the Titans portfolio. The average 3-year ROE is over 3x of that of the overall universe and over 2x the average ROE of private lenders.

Share Prices followed the tailwinds
Driven by all the positives, the share prices of lenders have also followed suit. The Bank Nifty index touched new highs, delivering a YTD return of 24%, significantly outperforming the Nifty, which delivered a 7.5% return in the same period.

Here is the abbreviated YTD price performance of the sector.

As can be seen from the chart, PSU lenders outperformed significantly due to their severe undervaluation compared to the private and frontline lenders. This tends to happen in normalization from a bad credit cycle. As the normalization is almost over, the stock prices will follow incremental fundamentals. We believe that the lenders in the Titans portfolio stand to gain due to their best-in-class fundamentals and their ability to grow at a decent pace while maintaining robust asset quality. In our view, financials is a multi-year theme and therefore we continue to be positive and overweight on the same.

Here is how our core portfolio strategies have performed in different time frames.

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