Comeback artist

What a great concept “context” is! If you look at the year that is just finishing, out of context, 2012 paints a pretty grim picture. GDP growth is down to 5.1%. Our current account deficit is ballooning, the rupee has depreciated to below 54 to a dollar and many corporates have seen earnings downgrades. Under these circumstances, the markets should be languishing.

Instead, from a low of about 4,555 around this time last year, Nifty is now trading around 5,900, up almost 30% in the past 12 months. This is because markets always tend to see events, not in isolation but in the context of what has gone before and what they expect to happen in the future.

In that sense, markets are reacting in the context of the year that immediately preceded this one. By all accounts, 2011 will go down as among the most challenging years for the market. The government was paralysed by a string of controversies and was unable to react to a worsening global and domestic macro-economic situation. 2012, on the other hand, provided a string of positive cues to the market — on the domestic as well as international front. Increased liquidity first, because of LTRO in Europe, and then QE3 in the US has meant the year has seen over $20 billion of FII inflows into Indian markets.

Then, there have been a slew of measures, some of them tough, to address the macro-economic situation. With economic policy-making back on track, markets believe it is only a matter of time before some of the other issues dogging the economy start to correct. That feeling is really behind the astonishing ride in the indices we have seen this year.

So what does 2013 hold for the Indian economy? It now seems almost certain GDP growth rate will not sink below 5.1% and will, in all probability, climb back to at least 6.5-7% levels. Underlying this belief is that with inflation now coming under control, the Reserve Bank of India, in an attempt to boost growth, will cut interest rates. A cut in interest rates will re-start the spending cycle by corporates. It would of course come as a huge boost to the infrastructure sector which has been through a rough ride over the last couple of years. Then, the government’s move toward direct cash transfer of subsidies will, if implemented properly, help plug leakages in the system. Another move that could prove to be a game-changer will be the implementation of the Goods and Services Tax, again slated for 2013. 

Given this context, what are the sectors that are likely to outperform the markets in 2013? Two sectors stand out — infrastructure and banking. Of course, both sectors have companies plagued by non-performing assets. For such companies, even with an interest rate cut, 2013 will be a challenge. But investing in companies with scale, good balance sheets, strong managements and a focus on cost are likely to yield handsome returns.

The standout stock of 2013 could be ICICI Bank. After passing through a tough cycle during the global meltdown, the bank’s efforts to improve the liability franchise while controlling expenses is now reflecting in its performance. Current account savings account (CASA) now accounts for 40% of deposits, up from 26% in FY08, even as costs trended down from 3.2% of assets in FY08 to 2.3% in FY12. 

After the bank bore the brunt of increased bad asset accumulation in 2008, the following year saw a restructuring and consolidation exercise.  

Concerns on asset quality rose from multiple sources: weakness in the retail assets pool, which saw continuous rating downgrades in security receipts; widening of credit spreads leading to a significant and unexpected hit on the bank’s credit derivatives positions on international financial institutions; and vulnerability to the global slowdown, given that international business contributed 25% of the consolidated assets. All this meant cautious growth and, hence, delayed improvement in leverage after the heavy dose of capital received by the bank in early FY08, which further depressed the return on equity. 

Hit on multiple fronts, ICICI Bank started focusing on consolidation in the near term. Growth moderated as the management was consolidating the retail portfolio, controlling incremental bad assets formation, focusing on improving its liability franchise, realigning the business model and rationalising costs. The process started with tightening of credit parameters, reduced reliance on direct selling agent (DSA) channel and strict control on costs. On the retail assets front, by sticking to its pricing (even in a declining interest rate environment) the bank’s products lost their attractiveness in the lending market. Reduced pace of retail disbursements and a shift in focus to branches for sourcing new business instead of DSAs led to considerable cost savings. Staff expenses were also kept stable while the focus on consolidation saw decline in advances for both FY09 and FY10.

Most importantly, with a cautious approach to asset growth, the bank altered its deposit profile in favour of low-cost retail deposits, primarily CASA. The result: a commendable 15 percentage points increase in CASA over four years. 

Now, ICICI Bank seems to have the right mix of scale, a management focused on controlling costs and a stable source of low cost funds to grow advances on the back of fully secured assets while maintaining margins. For 2013, we believe increasing pace of growth along with healthy margins will augur well for earnings. 

The past few quarters have seen improving margin profile from 2.5% range to 3% now and we expect the trend to be maintained going forward as well. The management, too, is confident of maintaining a 3% blended net interest margin on the back of adequate support from the overseas portfolio.

Aiding the bank’s growth and the margins is the controlled performance on the asset quality even in the midst of a challenging macroeconomic environment. Hence, despite much noise around asset quality, it has been consistently delivering above expectations. As seen in the previous few quarters and according to the management outlook as well, stressed assets are unlikely to play spoilsport in the bank’s earnings trajectory and we believe that the credit costs will be within the guided range of 75 basis points. 

Another standout is that after staying low for the past two years, the bank is now looking at strengthening the proportion of its retail assets. In that context, recent instances of the bank getting increasingly competitive on home loans and the car loans are a positive development. 

In a nutshell, improving leverage (as the bank has very healthy capitalisation numbers) and improving return on assets will lead to improvement in return on equity. We believe the standalone RoE will touch 15-16% by FY14E. The stock, which had hit a low of #250 during the 2008 credit crisis, has since bounced back and now trades closer to its five-year high of ₹1,200. Further positive development can be from the bank’s life insurance business where it enjoys a market leadership and things have stabilised post the regulatory overhaul. Hence, clarity on listing guidelines can add to the attractiveness of ICICI Bank.