The Opportunity in Indian Government Owned Banks

In my 20 years of investing I have learned that calling the bottom of anything is fraught with
danger. I am still going to go ahead and call a multi-decade bottom in India’s government owned
banks. Indian government owned banks remind me of where Indian government owned oil
marketing companies were in August 2013 except that the banks are even more depressed. In
August 2013, the dollar rupee exchange rate peaked at 69.00, oil peaked at USD 108 per barrel
and the government of the day refused to let oil marketing companies raise retail fuel prices. It
seemed then like the ventilator had been switched off on a critically ill ICU patient. Hindustan
Petroleum Corporation bottomed at INR 37 per share in August 2013 and today trades at INR
380 per share. The opportunity to make ten times one’s money in 4 ½ years in a plain vanilla
business like oil refining and marketing is possible only when one has the courage to invest
during times of extreme stress.

The narrative that has permeated the Indian financial sector over the last decade is that private
sector banks are good and that government owned banks are bad. That private sector banks
possess almost invincible superhero lending powers and that government owned banks are
dishonest, lethargic and incompetent. The story that has driven the valuation of private sector
banks through the roof and depressed the valuation of government banks is that private sector
banks are better in all aspects and that they will take market-share away from government owned
banks making them disappear into oblivion. The examples that are usually cited are those of
private telecom operators eating the lunch of government owned operators BSNL and MTNL
and private airlines taking away market share from Air India. While it is true that private sector
banks have been growing and gaining market share and government owned banks have been
losing market share, the above narrative and comparisons are completely false. Banking is a very
different business from telecom and airlines and the incumbents in banking are very strong
despite recent events.

With a multi-billion dollar fraud at Punjab National Bank (PNB) coming to light recently, it is
probably not the best time to say this but Indian government owned banks are not universally
corrupt and not all loans made are influenced by upper management corruption or government
interference. While the autonomy of government owned banks has improved dramatically during
the Modi administration, they were quite independent even under prior administrations. While I
am not a proponent of government ownership of any businesses including banks, privately
owned banks are no panacea for an economy. One must remember that the Global Financial
Crisis was created not by government owned but by privately owned financial institutions and
banks running amok.

India has experienced a severe economic and investment downturn in the previous 7 years. This
has been accompanied by a forced contraction of the economy by long term structural reforms
like GST implemented by the government. In such an environment, any bank with balance sheet
exposure to corporate loans has done poorly. The only banks that have managed to outperform
this contraction phase in the economy are HDFC Bank and Kotak Mahindra bank. There are a
handful of government owned banks like IDBI Bank and Central Bank of India that have done an
excessively poor job of managing their risk exposures, however in aggregate, government owned
banks have not done much worse that privately owned banks. The books of private sector banks
like Yes Bank and IndusInd bank are completely rotten. If a forensic audit of their books was
forced by the regulator, one would discover that both banks rank equal to or worse than IDBI
Bank and Central Bank in their loan books and processes. Private sector banks like Axis Bank
and ICICI Bank are no different from government owned banks except for their larger retail
franchises. Their books are equivalent to that of a State Bank of India or a Bank of Baroda and
they do not deserve a valuation premium over them. Old private sector banks like Karur Vysya
Bank, Karnataka Bank, South Indian Bank and City Union Bank all carry rotten books with
loans that have been discretionarily evergreened and are no different from government owned
banks in their performance.

Can HDFC Bank and Kotak Mahindra Bank take over the entire banking system in India in
time? And is there nothing wrong with the government banks in India? The edge that HDFC and
Kotak possess is exactly the mirror image of the weakness in government owned banks. HDFC
and Kotak are nimble and their model is to front run government owned banks. While much
noise has been made about their retail loan franchises, a disproportionate amount of their income
originates from providing high value fee-based services to companies where the fund-based
loans and balance sheet exposure is carried by government owned banks. Even where they have
exposed their balance sheet with fund based loans to companies, they have been quick to exit at
the first sign of trouble. Government owned banks on the other hand, are incredibly slow and
derive almost all their income from fund-based balance sheet lending. Their slow reaction time
has also made them victims of large scale fund diversions by fraudulent entrepreneurs. The
business models of HDFC Bank and Kotak Mahindra Bank have their limitations and their
opportunity is finite. As they become larger, the inevitability of fund-based lending by these
banks will become apparent. While they might still do a better job of exposure management than
government owned banks, their economics will change and their loan books will get impacted in
the next contraction cycle.

On the other hand, things are changing quickly and dramatically for government owned banks.
One can state with absolute certainty that government owned banks are now completely
autonomous. One can also state that the severity of the current bad loan cycle and the size of the
frauds and diversions that have come to light in this cycle have made the owner (the
government), the regulator (the RBI) and statutory agencies (the CVC, CBI and ED) and the
management and employees of these banks hyper-vigilant. The likelihood of these things
repeating and especially at the scale witnessed recently is almost zero. The banking sector in
India has been completely empowered with the passing and implementation of the Insolvency &
Bankruptcy Code (IBC). And finally, the mood of the nation and the administration is to undo
the Bank Nationalization Act of 1969 by which the government will be able to bring its
ownership in these banks below 51%. Once that happens, these banks will be free to recruit in
the way that commercially makes sense for them independent from the rules for employment in
government institutions.

Government owned banks are 70% of India’s banking system and this cannot be wished away.
If India has to grow at 8%+ rates, credit in the economy will have to expand and government
owned banks will have to grow. While employees at government owned banks may not be as
well exposed and as driven as those at privately owned banks, they are extremely competent and
understand the business of banking. They have not been empowered, motivated or threatened
and that has made them underperform. One can do adjusted book value calculations and state
that many of these banks are insolvent and therefore should not be bought. This would be grossly
understating the case for these banks. They possess bullet proof liability and low-cost deposit
franchises that have remained unshaken through this downturn due to the perceived sovereign
guarantee behind them. One just needs to speak with IDFC bank to understand how hard it is to
build a liability franchise and how much time it takes. Government owned banks also possess a
deep reach into the economy with their strong branch network and historical relationships with
companies and the general public. This gives them a phenomenal capacity to grow the asset and
lending side of their business profitably. This franchise will become invaluable as India’s
economy expands. One needs to speak with RBL bank to understand how hard it is to build reach
and a strong lending and asset franchise.

I believe that there are more than a few government owned banks that have solid businesses and
are trading at multi-decade lows. These select banks provide phenomenal asymmetries and
opportunities to generate superior returns over the next five years and are worthy of
consideration by investors.

Systemic Risk from Passive Investing

The active investment management industry has earned itself a terrible name. Two thirds of all equity mutual funds in the US underperform the S&P 500.  What is worse is that, as a group, investors in mutual funds underperform the funds themselves because of mistimed entries and exits.  Fees on actively managed funds including entry and exit loads are high. Their fees have made asset management companies and their star investment managers rich while delivering mediocre performances for investors. One is reminded of the title of a popular book about Wall Street called “Where are the customers’ yachts?”  When one looks at what is going on in the hedge fund industry, the situation is even more appalling. Hedge Funds on average have underperformed consistently and failed to deliver value despite charging egregiously high fees. No wonder then that there is a big backlash in the public pension space against allocations to hedge funds and a push toward passive investing at much lower costs.  

Warren Buffett in his letters to investors calls people in the investment management industry “helpers” who are out to take the wealthy “Gotrocks” family for a ride. He recommends that investors should fire (i.e. redeem) all their active managers and instead allocate a fixed amount periodically to a low cost index fund like Vanguard that replicates the S&P 500 index. It seems like the investing public is listening. Over the previous ten years, assets under management in actively managed mutual funds have declined as investors have shifted assets to passive funds like Vanguard and Exchange Traded Funds (ETFs). Interestingly this has put into motion two negative self fulfilling cycles. As more money heads into passive strategies, index stocks outperform non index stocks leading to further underperformance and consequent redemptions from active management. Also, as active managers become more obsessed with tracking error and benchmark underperformance, they start closet indexing their portfolios to reflect pseudo-index funds. With interest rates near zero and flows into equity markets continuing unabated, it appears like investors have discovered a new alchemy in passive investing.

It is important to stop for a moment and think about the staggering nature of the shift underway.This has very large consequences for investing and investors. If investing is all about flows and all about supply and demand of a particular security then the underlying and fundamentals do not matter. This would then be the anti-thesis of the fundamental value investing hypothesis proposed by Benjamin Graham that the market is a voting machine in the short term and a weighing machine in the long term.  

If there is any truth to Benjamin Graham’s hypothesis, the weighing machine will eventually overpower the voting machine. Given the size and duration of the passive investment trend, it is inevitable that equity indices and their linked passive investors will endure very long periods of underperformance. On the other hand, disciplined active investors who know what they are doing (a dwindling lot) will likely outperform the consensus for an extended period.

Voluntary Suspension of Disbelief

The dictionary defines suspension of disbelief as a willingness to suspend one's critical faculties and believe the unbelievable.  Suspension of disbelief is essential for the enjoyment of works of fiction like movies, books, magic shows etc.  However, we humans seem to excel in the art of disbelief suspension in many other areas of our lives as well.  Investing is at the top of that list.

In the words of Warren Buffett, price is what you pay and value is what you get.  But investing based on value is very difficult to practice.  Investing based on value requires one to take a position that the market is wrong.  Our belief in prices set by the market or to put another way, our willingness to suspend disbelief about the prices set by the market makes it hard for us to disagree with the value ascribed by those prices.  Once the link between the price of a security and the value of its underlying asset is broken due to the voluntary suspension of disbelief by market participants, interesting things start to happen.

Benjamin Graham noted that the market then becomes a voting machine instead of a weighing machine and success begets success and failure begets failure.  Graham had said that the markets behave like a voting machine in the short term and a weighing machine in the long term.  Unfortunately he did not define the duration of the long term.  John Maynard Keynes on the hand did articulate it and said that in the long term we are all dead.  

Recent experience in the markets would make one believe that the long term in the market is nothing but a series of short terms and since the market behaves like a voting machine in the short term, it should theoretically also behave the same way in the long term.  This hypothesis is being proved by the rise and rise of passive index based investing.   The most recent semiannual report on fund manager returns produced by S&P Global (SPIVA report) showed that 90% of actively managed US mutual funds underperformed their benchmark indices.  As an active money manager and one who makes a living picking stocks, I have managed to find myself in the 10% of managers who do beat their benchmarks.  However, I can tell you from experience that it has been incredibly hard to beat the index and it is getting increasingly harder to do so.

As more money goes into passive index based funds, demand for securities that make up the indices increases and their trading volumes and liquidity increases.  The increase in demand leads to higher prices for the indices and securities thereby creating more demand of index based funds.  As money skews towards indices and their components, it moves away from non index securities thereby depressing their prices, trading volumes and liquidity.  This amplifies the perception that securities in the index are safer than those not in the index and that larger companies, which by definition are in the index, are safer investments than smaller companies.  This phenomenon is exaggerated in emerging markets which are less liquid to begin with and are dependent on foreign capital flows.

It is important then to step away from this madness and ask whether the value of the underlying matters?  Does the market ever behave like a weighing machine?  Can the fictional and voluntary suspension of disbelief result in the emergence of an alternate reality?   If we truly are in an alternate reality then again in the words of Warren Buffett, I am out of touch with present conditions, and if not then I believe that this has to all end very badly.