HDFC & Kotak Bank: DOUBLE or Trouble? 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

RBI's orders to Kotak Bank to stop onboarding new mobile and online banking customers as well as cease issuing new credit cards, has certainly not gone down well with investors.

The stock has lost 1/10th or 10% of its value since then and is threatening to lose even more.

Thus, an underperforming stock has been pushed deeper into the underperforming territory.

In fact, I was looking at the 5-year performance of Kotak Bank along with two other private banks i.e. HDFC Bank and ICICI Bank.

Here's what I found.

Both HDFC Bank and Kotak Bank have been massive underperformers.

While the BSE Sensex has multiplied one's investments by almost 2x, HDFC Bank and Kotak Bank have done far worse.

In fact, an investment in the fixed deposit scheme of HDFC and Kotak would have given better returns than investment in their shares.

This is a massive underperformance whichever way you look at it.

ICICI Bank has been a star performer on the other hand.

Anybody who would have invested in ICICI Bank five years back would have almost tripled his money.

He would have done twice as well as the benchmark index.

And the less said about the outperformance of ICICI vis-a-vis HDFC and Kotak, the better.

Moving out of HDFC and Kotak and buying into the shares of ICICI, would have been one hell of a trade.

But why is it that HDFC and Kotak have underperformed and ICICI Bank has outperformed?

Well, I dug a little deeper into their share price performance and here's what I found.

HDFC Bank has gone up just 32% in the last five years because it has suffered a 30% contraction in its price to book value. As you can see, investors were willing to give HDFC Bank a price to book value multiple of 4.1x five years ago. However, now, they are willing to pay a multiple of only 3.0x.

In other words, they have become less optimistic as before about the future of HDFC Bank. HDFC's book value has grown by 83% between FY19 and FY23. But because it's price to book value multiple has dropped from 4.1x to 3x, the stock is up only 32% in the last five years.

Here, I guess I need to tell you why banks are valued on price to book and not price to earnings.

You see, a bank is in the business of managing assets and liabilities.

And hence, its book value, which is assets minus liabilities, reflects this core function.

The price to book value ratio then gives us an idea about the market's perspective of the quality of the bank's book value.

Besides, a bank's earnings are volatile in nature on account of things like other income, loan defaults etc. And this is also the reason price to book is the preferred metric of choice for valuing banks.

So, going back to our original discussion, Kotak bank has performed even more poorly than HDFC Bank. The reason is again the same. Investors have turned less optimistic towards the stock and are now willing to give it a price to book value multiple of only 2.8x against 4.4 earlier.

Thus, there's a huge 36.5% drop in the price to book value multiple of Kotak Bank, which has led to the stock going up just 18% in the last five years.

Again, like HDFC Bank, Kotak Bank has also grown its book value at a healthy rate of 86% between FY19 and FY23. But because its price to book value has contracted by almost 40%, its shares have given very poor returns.

ICICI Bank has been the surprise package. As you can see, its book value has grown at a lower rate as compared to HDFC Bank and Kotak Bank. However, it has still managed to give 184% returns over the last five years is because of the expansion in its price to book value multiple.

Its price to book value multiple has expanded from 2.3x to 3.8x, which is a massive jump of 63%. This means that investors are more optimistic about the bank's future now than they were five years ago.

Thus, moving from either Kotak Bank or HDFC Bank and into ICICI Bank, would have been a great decision five years back. It would have resulted into an almost tripling of investment. Not a bad return at all from a bank the size of ICICI.

Thus, the question that one needs to ask oneself is whether the time has come for a reverse switch. In other words, can a switch from ICICI Bank into HDFC or Kotak can pay off in a big way in 4-5 years the way a switch into ICICI has worked out? Can HDFC and Kotak outperform ICICI Bank going forward and beat the benchmark index?

You see, India is an underbanked as well as an under loaned economy. There is a still a long runway of growth when it comes to credit growth.

Thus, all the three banks with their strong franchises, their robust systems, their broad networks and their deep pockets are extremely well equipped to tap into this India growth story.

There is a strong probability that they can grow their book value at consistent rate of 15%-20% in the foreseeable future and like they have done in the past.

Hence, as long as they loan sensibly and don't accumulate a lot of bad NPAs, growth in the mid to high double digits is almost par for the course.

It is the other part of the equation that's tricky i.e. the price to book value multiple that should be assigned to these banks.

You see, both HDFC as well as Kotak Bank seem to be going through challenges of their own making in recent times. Both the banks have seen their legendary CEOs step down and both the banks are confronting operational challenges of a significant nature.

While HDFC Bank is still going through the merger pangs, Kotak Bank needs to set its compliance house in order after the rap on the knuckles by the RBI.

The good thing for both is that these challenges are surmountable if the management puts its mind and thought into them.

As you can see in this table, both HDFC Bank and Kotak Bank are trading significantly lower than their 10 Year average price to book value multiples.

ICICI Bank on the other hand is trading at a significant premium.

Hence, if HDFC Bank and Kotak Bank get their house in order and win the investor confidence, there is every chance they can climb back to their long-term price to book value multiples. And if this happens, share prices of both the banks can receive a big boost. They can even double over a period of 3-4 years. However, any delay or lapses in their operations, the price to book value multiple can stay at the current levels or even go lower.

Hence, the risk-reward equation does look in favour of both HDFC and Kotak Bank at the moment. Not only are their book values expected to grow but their price to book value multiples can also expand if they manage a quick turnaround.

ICICI Bank on the other hand, seems priced to perfection. An expansion in price to book value multiple from the current already high levels seems difficult if not impossible. On the other hand, even a small disappointment on the growth or the operational front, can make investors nervous and take the price to book value multiple much lower from here.

Hence, net-net, the odds do seem to favour HDFC Bank and Kotak Bank.

It is up to them to win back investor confidence and take its investors laughing all the way to the bank. Pun intended.

I will see you again next time. Happy Investing.