Why you should be careful while buying a bank stock and prefer to buy only sectoral mutual funds.
Yes, I know HDFC is the best stock ever. A perpetual multi-bagger. But check this post.
Banks are a beast. This is one industry that makes money out of money, is highly regulated and yet they break the rules often, and is super complicated. Banks make money by four main ways –
2. Trading of securities
3. Taking deposits
Almost all the other sources of revenues are some variant of the above.
So why not to buy banking stock?
A lot of people confuse banking stocks with other stocks; PE ratio, customer service quality, management quality, and blah blah. But remember, a bank must be judged only on its balance sheet and never on its income statement. Because reading the balance sheet of a bank is tough, I always ask people not to invest in bank stocks.
Why balance sheet only?
There are several reasons, and the main ones are-
a. Provisions- Bank knows that they won’t get their money back on most of the loans they give away. So they make provisions from their income every year to cover those losses. A bank can “manage provisions “ any year to alter its income statement significantly. This means there can be a huge profit when the bank is F****d
b. HFT- Banks keep Held-For-Trading bonds on their balance sheet. Every time interest rate and inflation moves, the value of this line item changes. Any decrease in this line item will mean the bank will have cut its exposure, and that will significantly affect the bank’s performance
c. Concentration Risk- A bank may be conservative, but its books may be focussed on one particular sector or division. Like HDFC is heavy on retail banking or IDFC on infra sector. This Concentration in exposure is good till the time is good, then the tide turns, the bank is destroyed.
Eventually, ratios like profit ratios, PE, PEG, EBITDA, Margins don’t work. We investors are wired to look for profit and YoY growth. We don’t have understanding or time to analyze the balance sheet plus the terminology is entirely different in banking.
Best is to buy the Banking Index fund or sector fund as a Fund manager will understand these things better. The guru mantra is – If you don’t understand the business, don’t invest in it.
I am very concerned about HDFC. It has continued to rise without a stop in the last 10yrs. It may be the first instance in the world where an FI has not been affected by industry-wise rout, mostly because banks are linked to each other and when one goes down, it takes the other one with it. Betting against history is too big a risk. Either HDFC is a black swan event or iska time bhi aayega!
Don’t ever think that retail banking moves the needle in the banking industry. Very few banks have a retail portfolio that can move the needle. HDFC and ICICI are two major ones. We know what happened to ICICI. The Subprime crisis was a typical case of a bank going overboard on one asset class. Banks were not foolish to give loans to anyone. They gave subprime loans so that they can make Mortgage-Back-Securities (MBS) and sell it off. The expectations were MBS gains will offset defaults in subprime lending. Unfortunately, they ended up multiplying their exposure to MBS without understating the base of the security, so the income statement kept looking wonderful while the balance sheet was destroyed. And then one day the music stopped