Public sector banks will take a few more years to match the valuations of private banks, but only if they resolve the key issues that are restricting their growth.

In a volatile market, it is a dilemma to choose between value (slow growth, low valuation) and growth stocks (high growth, high valuation).

A classic example to prove this fact is the Indian banking sector, which is dominated by large number of public sector banks (PSBs) which come under the value category whereas the private banks are classified as growth stocks.

This is because PSBs, despite having huge network (branches) and employee base, lag behind their private sector counterparts, which are far ahead in terms of technology, products and processes. And thus comes the valuations gap.

Market participants and even fund managers feel that the gap can be narrowed only when PSBs catch up with their private counterparts in terms of people, products and processes and solve the issues like employee compensation and attrition, besides pushing towards consolidation and mergers.

As of today, given the higher growth prospects and visibility, they prefer the private sector banks despite their high valuations.

Says Nilesh Shah, deputy managing director, Prudential ICICI Mutual Fund, "Private banks are preferred over the long term due to better growth prospects and visibility." He adds that public sector banks have hidden value, but how much time it will take to unlock is not known.

An analyst from a broking firm agrees with Shah and points out, "Private banks have offered consistent financial performance, higher growth rates and are ranked higher when it comes to service and product offerings."

Having said that, one cannot rule out the PSBs, as there are some stocks worth considering. But first, a look at why investing in the banking space makes good sense. Refer table, Top Picks, to find out which stocks are worth investing in.

A play on the India growth story

The BSE Bankex index has outperformed the BSE Sensex for the past one year as well as the last six months.

While the Sensex has gained 44 per cent in the last one year (31 per cent in past six months), the BSE Bankex has zipped past with 57 per cent gain (34 per cent in six months).

But, does this euphoria for Indian banking stocks justify investments at the current levels, especially given the market conditions where credit growth is slowing, margins are under pressure and domestic interest rates are still high as compared to the trend in global markets?

Experts believe that investors should be invested in the banking sector for the long-term as it is a direct beneficiary of the robust economic activity in the country.

Moreover, industry players feel that credit growth will pick up as demand from infrastructure projects and corporates is strong. However, maintenance of margins has been and will continue to be a challenge.

Says Anil Khandelwal, chairman and managing director (CMD), Bank of Baroda [Get Quote] (BoB), "Indian public sector banks will have to work hard to maintain their margins." 

Adds another senior official from a leading public sector bank, "We will have to live with smaller margins as compared to the past."

However, lower margins is not the case with PSBs alone as most private banks too have seen a dip in margins in the recent past. That is because, as term-deposit rates had moved up, the CASA (current and savings account) deposits, which are a source of low cost funds, fell for most banks.

Going forward, how will margins scenario pan out? The answers are not simple as it will depend on the movement in deposit rates and the lending rates. And, this is what experts have to say on interest rates.

M B N Rao, CMD, Canara Bank [Get Quote] says, "Indian rates need not follow the US Federal Reserve's rate cuts as there is enough liquidity and our financial system is strong and stable."

Adds Khandelwal of BoB, "There is little possibility of interest rates declining as banks are increasing their balance sheet size with the financial year end (March) approaching."

Moreover, bulk deposit rates are still moving up, he adds. However Manish Sonthalia, vice-president, equity strategy, Motilal Oswal Securities has a different view.

"Indian interest rates are headed lower in the next two months due to a surge in deposits and global indicators like rate cuts by the US Fed and global central banks injecting money in their financial system." To sum up, it seems that Indian banks should at worst manage to maintain margins at current levels.  

TOP PICKS
PRIVATE BANKS	PUBLIC SECTOR BANKS
ICICI Bank [Get Quote]	State Bank of [Get Quote] India
* Largest private sector bank * Market leadership in retail lending * Value unlocking in insurance, mutual fund and broking subsidiaries * Focus on rural and international operations	* Country's biggest bank and market leader * Largest branch network (including subsidiaries) * Value unlocking due to merger of its associate
HDFC Bank [Get Quote]	Bank of Baroda
* Consistent financial performance with over 30 per cent net profit growth year-on-year * Best net interest margins (4 per cent) and CASA ratio (52.5 per cent) in the industry * High quality assets	* Among the top five public sector banks * Strategy of profitable growth * Making substantial presence in international markets * Formed joint ventures in life insurance and asset management businesses
Axis Bank	Union Bank of [Get Quote] India
* New generation private sector bank * Investing in branch expansion, ATM network, technology and manpower * Foray in international business and mutual funds * Focus on corporate and SME loans	* Strong presence in Western and Northern India * Increased focus on training, technology implementation and risk management * Venturing into emerging markets like Middle East and Asian countries * Geared up for core banking solutions
Kotak Mahindra Bank [Get Quote]	Indian Overseas Bank [Get Quote]
* Integrated financial service provider * Leading position in broking and investment banking business * Banking business to grow manifold due to huge investments	* Dominant presence in South India * Superior NIMs (3.5 per cent) and return on equity (29 per cent in FY07) among public sector banks  * Consistent financial performance

Private vs public

In this scenario, what should investors do? For now, the private banks seem to find favour, thanks to their ability to sustain higher growth rates, helped by robust growth in other income (which includes fee-based services, commission and brokerage).

A look at India's top two banks by market capitalisation, ICICI Bank (the largest private bank) and State Bank of India [Get Quote] (SBI; the largest Indian bank [Get Quote]), proves the point.

But, the silver lining here is that PSBs are catching up (See PSBs shoring up other income) and showing considerable improvement on the other income front. 

PSBs: SHORING UP OTHER INCOME
% chg (y-o-y)	Net Interest Income			Other Income			Profit Before Tax (PBT)			Net Interest Margin (%)
	FY06	FY07	H1FY08	FY06	FY07	H1FY08	FY06	FY07	H1FY08	FY06	FY07	Q2FY08
Private banks
ICICI Bank	65.86	40.93	24.58	22.39	41.82	46.73	26.67	22.45	59.90	2.70	2.60	2.20
HDFC Bank	43.19	45.71	37.33	72.56	34.90	44.95	30.83	31.08	42.70	3.60	4.20	4.00
Kotak Mahindra Bank	68.51	72.35	90.01	64.66	30.07	78.23	39.27	19.56	97.80	5.10	5.20	5.20
AXIS Bank	47.47	45.34	56.34	75.47	38.44	78.95	44.98	35.86	64.80	2.90	2.90	2.90
Centurion BOP	124.17	42.84	26.27	196.65	89.30	71.40	249.66	38.25	40.40	4.60	4.50	3.20
Yes Bank [Get Quote]	385.87	94.53	83.21	434.54	100.35	109.36	LTP	70.57	110.70	3.30	2.80	2.90
Federal Bank [Get Quote]	19.42	22.11	22.38	2.35	32.15	39.83	149.99	29.98	68.70	3.10	3.10	3.20
Jammu & Kashmir Bank	11.32	15.69	3.66	15.30	44.53	63.22	53.68	55.16	25.20	2.70	2.90	3.00
IndusInd Bank [Get Quote]	-24.17	-13.87	16.56	-24.69	29.28	22.81	-82.48	85.28	33.00	NA	NA	NA
ING Vysya Bank [Get Quote]	34.88	12.65	11.42	13.45	39.62	56.94	LTP	881.72	-445.20	NA	NA	NA
Public sector banks
State Bank of India	11.79	2.98	5.54	4.43	-22.41	34.58	2.37	3.06	29.90	3.40	3.30	2.60
Punjab National Bank [Get Quote]	16.47	18.17	3.90	-24.00	-18.15	45.14	2.07	7.00	7.90	3.40	3.50	3.50
Bank of India	17.66	30.72	-27.04	2.47	31.96	37.01	106.28	60.12	-38.40	2.80	3.50	3.60
Bank of Baroda	6.57	19.25	12.76	-14.16	4.07	37.54	22.18	24.13	47.50	3.60	2.30	2.90
Canara Bank	13.68	12.43	-12.86	-14.79	10.29	76.09	21.06	5.78	15.40	3.40	3.20	NA
IDBI	102.23	73.19	-10.57	104.18	-19.78	80.81	82.55	12.38	11.50	0.50	0.70	0.60
Union Bank of India	15.00	17.52	14.43	-35.45	38.84	61.43	-6.10	25.21	39.30	3.10	3.00	2.70
Indian Overseas Bank	11.41	23.88	12.94	-32.32	-28.47	100.39	20.26	28.73	16.70	4.10	4.00	3.40
Oriental Bank of [Get Quote] Comm	5.34	5.37	2.29	9.42	9.13	2.28	-23.26	4.24	-4.30	3.00	2.70	2.40
LTP indicates loss to profit Source: BS Research Bureau  and Analyst Reports

Almost all the top ten PSBs by market capitalisation have increased the share of other income in their H1 FY08 total income as compared to declining trend between FY05-07.

Industry experts feel that this increasing share of the other income will continue with new business opportunities (distribution of third party products like insurance and mutual funds) and full benefits of investment in technology.

Says Sonthalia, "With India's GDP of Rs 1 trillion expected to double in the next five to six years, savings rate will also improve from the current 32-33 per cent."

He adds, "Public sector banks will show a higher rise in other income as private banks are already strong in this area and hence, the growth rate may not be as high, due to the base effect." But, that may take a few years to materialise.

For the time being and considering the visibility aspect, market participants prefer private banks. However, the key apprehension is that private banks quote at higher valuations making them susceptible for corrections.

Says Sandip Sabharwal, chief investment officer, JM Financial [Get Quote] Mutual Fund, "Private banks will outperform in the long term though we look at PSBs if there are trading opportunities available in the short to medium term."

On the other hand, Sonthalia recommends public sector banks due to greater safety of capital and comfort in terms of reasonable valuations.

Valuation gap to continue

While valuations for PSBs are lower, they are expected to remain so for some time. To give some examples, ICICI Bank is ahead of SBI in terms of market capitalisation.

Similarly, HDFC Bank -- whose advances are half that of second largest public sector bank, Punjab National Bank, has double the market cap of the latter.

Market participants feel that this valuation gap between private banks and PSBs will continue until PSBs resolve issues like government intervention, uncertainty over consolidation and mergers, employee compensation and attrition, which is a bigger threat than the entry of foreign banks post-2009. Read Progress Report for implication of these key issues.