Banking stocks attract a large crowd of first-time investors in India, partly because everyone uses a bank and feels familiar with the business. Familiarity, however, is not the same as analysis. Many people open a trading app, check the ICICI Bank share price once, and assume they understand the sector. Others see the IDBI share price move sharply on some news item and jump in without knowing the reason. A simple, repeatable checklist can save you from such impulsive choices and help you invest with confidence.
Start With the Basics of the Business
A bank is not a manufacturing company. Its raw material is money, and its biggest risk is default on loans. Before anything else, learn how the bank earns. Its primary source is net interest income, i.e., the difference between the interest it receives on loans and the interest it pays on deposits. Fees from services, treasury operations and insurance distribution make additional contributions. Now glance through a few lines on the latest quarterly results of the bank and see how these components are trending. If the interest income is rising but the provisions are rising at a faster rate, the situation is less rosy than the profit number suggests. This type of basic understanding of the business puts you ahead of the pack.
Asset Quality Comes First
The most important aspect for examining any bank is the loan book. Gross non-performing assets indicate the percentage of loans on which the borrower has defaulted. Net non-performing assets show the portion of the default amount that has been covered by the lender. Lower trends in both are worth noting. Similarly, a higher provision coverage ratio means that there is less room for unpleasant surprises in the future. Look out also for the loan book that has the most amount of risky exposure such as unsecured personal loans or those disbursed in stressed sectors as it reflects badly if such a segment defaults. The banks that are transparent about the figures are more trustworthy.
Valuation, Deposits and Capital
Next, arrive at a fair valuation of the bank. It is customary to use the price-to-book ratio for banks as compared to the price-to-earnings ratio used otherwise. Examine this ratio with respect to the bank’s own performance history as well as those of comparable lenders. A premium on the book value is fine, given that the return on equity has been consistently high, otherwise, it ought to be a cause for concern. Simultaneously, take note of the deposit base. A large amount of current or savings account deposits implies cheap funding for the bank. As a related parameter to consider here is the capital adequacy ratio; a bank with sufficient capital can grow its balance sheet and also withstand market slumps without having to resort to diluting its shareholders’ stake.
Avoiding Common Mistakes
There are some common pitfalls that one must avoid when one begins to invest in banks. The first is to buy just because one has seen the stock price rise. The next common mistake is to judge a stock purely on the basis of its price and buy the ones that seem cheap. After all, it is the value that matters. In fact, the ‘value’ is arrived at by considering the total number of outstanding shares of a company and its performance. So, another way of looking at this is that unless one knows what drives the value of the stock, one should not purchase it. Another thing that one must not do is ignore ownership and regulatory aspects. Such issues hold the potential to transform an entire business scenario. There is also the risk of over-concentration: putting in too much money in two or three banks can expose one to the same risk. A diversified portfolio of banks across different sectors is the best way to mitigate risks. Systematic investing, as opposed to lump sum investing, is yet another good way of averaging out investment levels so as not to be tempted to invest at market tops. Maintain a log of reasons for every stock that you buy and re-examine them every quarter. If the reasons still hold, it is time to sit tight. On the other hand, if the situations have changed, be it for better or worse, take timely action. Being consistent is far more important than being excited.
