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Financial sector bets: Pick high quality financial stocks available at attractive valuations: Marcellus Investment Managers


Given the state of economic activity, even the best quality lenders will see an increase in NPAs, says Founder Pramod Gubbi.

The last time we interacted, you had said that if we get more and more bad news on the coronavirus front, it could trigger further downfall for the market. But somehow, while we have seen quite a bit of pain, there has also been that burst of exuberance. What do you make of that? Is that justified in nature with things globally improving or do you think it is just irrational in nature?

I do not think it is irrational because a lot of the rally has been driven by this huge amount of liquidity that the western central banks have pumped in both in terms of monetary stimulus and the government implementing fiscal stimulus; the number goes up north of $5 trillion. So I do not think the markets can ignore that and that is clearly the explanation.

Having said that, there is reason to be positive from a relatively longer term basis. First, you need to assume that given the sort of effort that is going on globally to find a vaccine and a cure, pretty much the bulk of the pharma and the biotech industry is behind this. There are billions of dollars of expenses running behind it. You have to be positive that in the next 12 to 18 months, we will have to at least reasonably tackle this issue and the world will return to normalcy. You can get a glimpse of what is happening in East Asia, particularly in China when lockdowns have been lifted. So you know what is likely to happen to demand and economic activity. Some of the numbers that we are receiving from China have clearly surprised us; like the Disneyland ticket selling out or Airbnb shoot up in sales or even auto sales picking up. So I sense if you are willing to take a relatively longer term view, there is reason to be positive both from a rational economic standpoint as well as the sort of liquidity and stimulus support that we are getting from governments and central banks globally.

Let us talk about where the opportunity lies. Some sectors are seeing very lucrative valuations as well. Do you reckon that it is a good time to buy and which would be those particular spaces according to you?

The big call that investors need to make is if you are indeed willing to take that relatively longer term view. You need to make a call on which are the companies which will be able to best survive this sort of crisis period because in the interim, there will be pain and it does not take a genius to say that we are in a recessionary environment as looking out my window I can make that call. Perhaps the same will persist for a relatively extended period of time even if the lockdown gets lifted on Monday.

Given the sort of exodus of migrant workers, there could be labour issues. Given there are balance sheet issues with several firms, I do not think the pain will go away in the short term. Therefore, it is important for investors to pick and choose companies which are best positioned to weather this storm and you can make a call based on two or three factors. One is to look at the balance sheet. See if the balance sheet has enough ammunition to survive to be able to handle those fixed costs with not much of a revenue and hence the strength of the balance sheet becomes a key characteristic of a company that you will choose.

Second, it should be in a business where the demand for your goods and services are not completely discretionary which some consumers will postpone forever. It can be postponed for a short term or maybe they are even essential for their daily lives during the lockdown. Third is the relative comparative advantage. It is clear that this painful period will result in consolidation across sectors. There will be stronger companies in every sector which will emerge even stronger with the larger market share and whenever the recovery happens, it is a goldilocks scenario for these companies because there will be few companies which are left and they have gained disproportionately upon that recovery.

So the whole focus should be on being able to survive this crisis rather than trying to be very opportunistic in terms of valuations of its own, particularly in the case of financials which have been most beaten down. You asked about sectors. I think this is one sector where even some of the really good franchises with very strong balance sheets, very strong liability franchises are trading at really attractive valuations and if you were to get opportunistic on a valuation basis, I think do not look beyond quality financials.

Are you not a little concerned after what we have seen from ICICI Bank or for that matter the way the market has been punishing SBI? There is no denying that it is a right buy right now but it is even below the March lows, grinding at a 52-week low and still sinking further.

What I talked about in terms of looking for characteristics which will make somebody survive the crisis is even more amplified in the case of financials. Simply because financials are leverage bets where the capital is leveraged to the extent of the debt to equity and therefore they are always a high beta sector. So in the upturn, they always outperform the markets and vice versa during the downturn. Therefore, the need to look at survival is even more exacerbating in the case of financials.

I do not think any of us will be surprised that NPAs will go up. Given the state of economic activity, even the best quality lenders will see an increase in NPAs. There might be a differential to what extent NPAs rise for some banks and NPAs of A versus B versus the rest of the sector but by and large, most of the sector will see an increase in NPAs. However, the answer to whether the banks and NBFCs will survive this extended period of lockdown or slowdown in economic activity does not apply on the asset side; it is more on the liability side.

We need to look at a) the capital adequacy; whether the equity base of the bank or NBFC in question is strong enough to survive a significant increase in NPA and b) we need to look at the deposit rates. If the deposit base is sticky, is of long enough duration that you do not have to face refinancing risks, typically any deposit base with largely retail fixed deposits, preferably longer tenure including CASA and term deposits is always an indication of a very strong balance sheet.

It is a calculated risk whether banks or NBFCs in question will be able to survive this crisis. There are several banks and NBFCs which are reliant on wholesale deposits. Particularly given the issue with mutual funds on the debt mutual funds side they will be strapped off liquidity and that can cause survival issues. But on the other hand, if you are retail focussed on the liability side with a strong capital adequacy ratio, the chances that you will emerge out stronger on the other side are quite high and those should be the bets that you need to make on the financial sector.

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