Jan 2014: HDFC Bank: When the going gets tough

This month we would like to discuss one of our high conviction investments – HDFC Bank. HDFC Bank’s key edge over competitors is its liability franchise, its ability to gather low cost, current and savings account (CASA) deposits which is among the highest in the industry, averaging 50% over the last decade. The low cost of its deposits is a great competitive advantage because it allows HDFC Bank to cherry pick high quality customers to lend to, and yet maintain a net interest margin which is among the highest in the industry. HDFC Bank is the most efficient player in the banking industry with among the lowest cost to income ratios. It has the best NPA record with gross NPAs (including standard restructured assets (SRA)) of about 1.5% and provisions for doubtful debts which exceed 200% of the gross NPAs. The rest of the industry has an estimated average gross NPA (including SRA) of 9.4% and provisions of an estimated 24%.
The Indian banking industry has grown at 17.5% over the last 50 years. The market continues to be underpenetrated as credit as a percentage of GDP is much lower than global standards. HDFC Bank is able to continuously gain market share over public sector banks (78% of the banking industry) because of certain inherent disadvantages of PSU banks. For one, PSU banks are always short of capital, because banks routinely need to raise capital to shore up their capital adequacy. The government does not have the money to keep funding the PSU banks adequately and has an ideological issue with letting its stake fall below 51%. Political interference is another disadvantage that the PSU banks face and we don’t think it is a coincidence that the gross NPAs of PSU banks are much higher than that of the private sector banks. As a result of these competitive advantages, HDFC Bank has grown its deposits base at 30% over the last 10 years as against 17% for the entire banking sector. Despite this trailblazing growth, its market share is only 4.4% as of now.
Over the last 5 years, when things have been rather rough for the Indian banking sector, with rising NPAs and a large restructuring of assets, HDFC Bank’s gross NPAs including restructured assets have averaged 1.5%. What we like further is that the bank has used these tough times to cut expenses sharply – cost to income ratio was at 42.7% in the latest quarter while it has averaged 48.5% over the last 5 years. It has achieved this while it continues to roll out into large hitherto unbanked areas. From 327 cities that it covered in 2008, it now covers 2,104 cities/towns.
What makes HDFC Bank interesting at this point of time is that there is a technical overhang in the stock. The RBI notified on 16th December 2013 that further FII and NRI buying in the stock is not permitted because the FII limit of 49% has been crossed. As a consequence, the MSCI Index has cut its weightage for HDFC Bank in its India Index from 7.05% to 5.34%. So, not only are FIIs, which are the largest factor on the margin in the Indian stock market, not permitted to buy the stock incrementally, there is a fair amount of forced selling because of the weightage change by MSCI. When a great company is available cheap because of technical factors, it often presents the perfect opportunity to get into the stock.