PSU BANK STOCKS

PSU Bank stocks are starting to look somewhat like the Indian cricket team after they ran into Mendis in the Asia Cup. Battered and bruised. But these stocks, currently out of favour could provide a mix of steady income and capital growth to investors' portfolios. Let's look at some reasons as to why PSU Banks are now discarded by the public.

1. It is felt that PSU Banks' profit margins would be eroded due to mark to market losses on their treasury holdings. While this is true, banks generally hold these bonds to their maturity. So while mark to market losses could dent their margins in the short run, these would provide above normal profits when interest rates cool off. Even if interest rates do not ease, these bonds would continue to provide interest at the coupon rates and on maturity the entire principal would be received by the bank.
2. Due to rising interest rates demand for loans would decrease. Again PSU banks are not aggressive in their approach to giving out loans to people. In fact this conservatism was said to be one of their drawbacks when the going was good. With the current scenario, where private sector banks are being downgraded because of NPA fears, PSU banks are relatively well insulated from NPA'. Though demand growth may slow down somewhat, PSU banks are well equipped to handle this because of their diverse clientele and their reach in rural areas. Since it is expected that agricultural growth will be better this year, PSU banks are well poised to capture a part of this growth to make up for demand slowdown from cities and corporate.
3. Rising interest rates would put margins under pressure, because of higher cost of funds. This would also work to the advantage of PSU banks because of their larger base of CASA (Current And Savings Accounts) deposits. Here banks have access to a large pool of funds at extremely cheap rates. This would partly offset the higher cost of funds, at which they borrow for term deposits and other longer term borrowings.

Now for some reasons, as to why PSU banks are excellent investment candidates at current levels.

1. Most of these banks are available at or below their book value. These businesses are not going to disappear from the Indian markets in a hurry. Then why give them such abysmally low valuations? Most of them own huge pieces of real estate, in prime locations. These are generally being carried on the books of the banks at cost price. So, if the treasury holdings of banks are marked to market, then the real estate should also reflect current market prices. If this is done then the disparity between book value and market price could widen further.
2. The current dividend yield on PSU bank stocks works out to anywhere between 4 to 6%. This is one category which offers the highest dividend amongst all the available sectors in India. Although, if profits decrease, the banks might lower dividends, but in the longer term they have a history of paying out a large portion of their profits in the form of dividends. So eventually the dividend payouts ought to revert to their mean. In fact the high dividend yields give investors some kind of protection against further sharp downsides in stock prices.
3. Most banks have modernised their operations, downsized excess staff and improved service levels. Gone are the days when they operated from dingy branches with grumpy clerks. The PSU banks of now are the match of their private counterparts in terms of ambience and ease of banking. Not only that, they also have a human interface for customers who are not comfortable with handling computers and ATM', unlike private banks.
4. PSU banks are being discounted at 4 to 5 times past year' earnings. Although earnings are expected to come down in the current year, as discussed above, this is likely to be a temporary phenomenon. Since markets have a tendency to discount the future by about 6 months, the stock prices of these banks could rise well before interest rates start easing.

Then again there are some intangible factors which work in favour of PSU banks. Customer loyalty is one of them. Then the low cost of operating accounts unlike private banks which charge customers for every small service. According to a Assocham survey in 2006, 60 % of Indian businessmen prefer PSU banks for sourcing credit cards and 80 % of them approach PSU banks for personal and educational loans. As mentioned above their rural reach, access to cheap funds via CASA and diverse client base give PSU banks an invaluable brand equity.

Future prospects include disinvestment by the Government, which could provide a real trigger to stock prices. Consolidation among banks is likely to take place in 2009, when several PSU banks are expected to merge to acquire size and financial muscle to take on foreign banks

Risks associated with PSU banks include Government interference in the form of farm loan waivers and tendencies to favour political constituencies through banks. Inability to face competition from foreign banks, which are expected to hit Indian markets due to opening up of the banking sector in 2009 could be a negative. Even the larger PSU banks are considered miniscule when compared to their global counterparts. This lack of size could hamper the growth of these banks. Lack of autonomy in incentivising employees to improve productivity and retention of key employees could be a concern.

VALUE BUY – AUROBINDO PHARMA

Aurobindo Pharma is a manufacturer of Active Pharmaceutical Ingredients (API'), formulations and intermediates, having a wide portfolio of products in various segments such as anti infectives, anti retrovirals, cardiovascular systems , CNS etc.

Strengths:

It has 5 units for manufacture of API' and 4 for manufacture of formulations, catering to regulated markets where norms relating to manufacture are extremely stringent. It has invested heavily in modernizing its plants to make them compliant with USFDA/European standards. This is a significant step in improving quality standards and would be beneficial to the company in the long run. A significant presence in US markets is accounted by a large number of approvals from the USFDA. In addition the company is in the process of filing for 30 more drug approvals in the coming years. Acquisition of Milmet Pharma (UK) and Prarmcin (Netherlands) has given it the required presence in major European markets. It has maintained its efforts to increase its presence in Europe by filing drug master files in various European countries. About 40 products are awaiting approval in various European countries, which could be a significant driver of revenues and profits going forward. In May 08 it has received 9 product approvals from MCC to market products in South Africa. It has now a total of 31 marketing authorisations approved by MCC.

Since the company manufactures a majority of the intermediates required for the manufacture of API', it has been relatively insulated from the cost pressures due to rising intermediate costs affecting a majority of its competitors. The company has focussed on diversifying its product portfolio by going into the formulations business, which is likely to impact bottom lines positively since formulations is typically a higher margin business as compared to API'.

Risks:

Prices of chemicals and intermediate inputs are on the rise due to the global commodities boom. This could have an adverse impact on the bottom line of the company.

The company operates in regulated markets of the US and Europe. Delays in the approval of drugs can have an effect on new launches thereby putting a constraint on the growth of the business. Also the quality parameters not only with respect to the final product, but also in the practices followed in their manufacture are very stringent, any slip ups can cause serious problems.

Financials:
For the year ended March 08, the company achieved sales of Rs.2234 crores, a growth of 19 % over the previous year.
Profits increased from Rs.229 cr. to Rs.290 cr. A growth of 27 %. However this was aided by an increase in other income from Rs.39 cr. To Rs.118 cr.
The EPS for the year stands at 53 giving a PE ratio of 5.5 at current prices. If other income is excluded, it gives an EPS from operations of 32.
The real undervaluation of this company is observed in its balance sheet. The company has Net Current Assets of Rs.1800 cr. as on 31.3.07. Against this the Market Capitalisation is just Rs.1500 cr. on date. This makes Aurobindo Pharma a real value buy.

IN DEFENSE OF FUND MANAGERS

There has been a lot of mutual fund bashing going on recently, with investors upset that fund managers have not been able to protect investors in the current downside. I am also guilty of criticizing these guys in a previous post. Everyone wants a scapegoat when things go wrong. But I now think we ought to take a relook at what went wrong with the decisions that fund managers made and were they entirely responsible for not saving investors from the terrible erosion in values that has taken place. I would not go so far as to say that there was nothing they could have done to protect investors, but given the circumstances it was extremely difficult to act any other way.

It has been said that funds did not take profits at higher levels. I think that, even though funds did book profits, by mandate an equity fund has to have a majority of its corpus in equity. Being in another asset class is not a call for a fund manager to take. When investors have given him the money to deploy in shares it means that they have studied the implications of having a portion of their assets invested in equity, with the associated risks. If investors had indeed wanted fund managers to periodically rebalance their portfolios, they should have invested in the various asset allocator mutual fund options in the markets or, opted for the dividend payout option. Let's face it, it was our greed that got us to invest in pure equity funds and not sell the units at higher levels.

Another point people make is that fund values have fallen more than the benchmark indices, which is quite true. But one has to realise that however diversified a fund might be, it's portfolio is still quite concentrated when one compares it to its benchmark index. The concentration may not be in the number of scrips held, they may be quite diversified but a large percentage of the fund's assets are concentrated in a few top holdings. Generally a large cap fund has about 45 to 50 % of its holdings in 10 stocks. This is exactly what enables an actively managed fund to outperform the indices when they go up. It is but natural that the converse should be expected to hold true on the way down. If the past 5 year track record of the top funds is compared with that of the indices, we find that the funds have hugely outperformed.

A criticism that I have also made in the past is that the fund managers were invested heavily in flavour of the month stocks like infrastructure and real estate. But as investors, our investment psyche is such that we generally look at how well funds have done over a 1 year period. We then invest in last year's better performers. In doing so, we do not allow fund managers to take a longer term call. If investors focussed on 3-5 years returns, I feel fund managers would be emboldened to avoid hot stocks which are overpriced and concentrate on value instead. Whichever way one looks at it, a fund has to have assets under management, to stay in the business. Assets can only be garnered by showing fantastic returns in the short term.

I have recently seen the concept of SIP' being attacked as not being a suitable investment strategy. I would like to differ on this. ICICI Prudential Growth Plan, not one of the top ranked funds, has given SIP returns of 18.57 % over a 3 year period and 29.60 % over a 5 year period. I have deliberately not included a top performing fund, in order to give readers an idea of the average fund returns. Returns are as on 31.05.08. Anyway, the best method of judging a SIP is when the markets have recovered after being down for a while. This is where the benefits of Rupee cost averaging works out. If the markets have fallen precipitously as they have done recently, investors do not get time to accumulate enough units at lower levels. The error in estimating the efficacy of this strategy is compounded when the lowest NAV' are used for calculating the returns. In my view SIP is an extremely efficient and simple way to create wealth in stock markets. If an investor sticks to his SIP plan, I am sure that when markets recover, he would be amply rewarded for his discipline and persistence.

The above does not in any way absolve fund managers from their duties as guardians of public wealth, but we, as investors, need to realise that they are after all human and are subject to the same failings as we are. They have done an admirable job in the past in beating market returns and can be expected to do so in future, if we allow them some leeway and time to get their act together again.

LESSONS FROM JAN 08

What percentage of the Indian investor population regrets not getting out at 21000? My guess would be 95 %. Even long term investors are shocked to see the value erosion in their portfolios now. Some of them are even thinking of cashing out, while they still have some profits left on the table. Panic is slowly creeping into the markets as stock values are rapidly eroded.

Looking back it seems that we all got too greedy. But aren't we doing the exact opposite right now by becoming too fearful? We felt that markets would never come down and miscellaneous analysts were egging us on by outdoing each other in predicting higher sensex levels. Some of us were afraid to sell thinking that we would miss out on the gains of tomorrow. The exact reverse is happening at the present moment. When so-called support levels are breached, analysts predict still lower levels. We are afraid that if we buy a stock today, tomorrow it will be available 5 % cheaper.

I am not saying we are at the bottom. I don't profess to know what the bottom is and am not interested in guessing. But I do know that valuations are attractive, just as they were stretched in January. Just like various theories were bandied about to justify high valuations, doomsday scenarios are being painted now.

One cannot sell at the exact top or buy at the bottom. We can take a call based on reasoned past and present indicators and a likely future scenario. Had someone taken a valuation call in December 07 and sold out at 18000, he would have seemed foolish initially as markets rallied another 12 % or so. But in hindsight his actions would have looked extremely wise. Similarly a purchase now might look foolhardy, but it is certain to pay off handsomely in the next 12 months. We need to learn lessons that history teaches us, if we are to profit from the folly of others.