There's a buying opportunity in India's banks. How to capitalize on it

Published Thu, May 11 202311:38 AM EDTUpdated Thu, May 11 20233:41 PM EDT

As investors start to find Indian equities attractive once more, they can pick opportunities in one area that's generating significant interest: the banking sector. Indian equities are lagging this year, with many investors finding the market too expensive after its outperformance last year. The iShares MSCI India ETF (INDA) is down 0.9% in 2023, while the iShares MSCI Emerging Markets ETF (EEM) is up 2.3%. Recently, however, that trend has started to reverse. The INDA is 5.1% higher this quarter, while EEM is off roughly 1.7%. One reason investors can't stay away from the market for long is the country's size. With 1.4 billion people, India's population is expected to have surpassed mainland China's last month to become the most-populous country on the planet. That trend is also expected to continue, according to the United Nations. The country also has relatively young workers powering its labor force. INDA YTD mountain iShares MSCI India ETF YTD For investors, this suggests a buying opportunity in the country's banking sector. Despite its population, India remains a highly underbanked country and any growth could spell huge upside for its financial institutions. "In a global sense, people get very excited about fintech in financials. People get excited about the level of customer growth in fintech, but there's often an issue with profitability in fintech. Hardly any fintechs make money or have a clear plan to make money," said Paul Desoisa, co-portfolio manager of the Global Emerging Markets strategy at Martin Currie, a specialist investment manager of Franklin Templeton. "But, in Indian banking, we actually have exceptional customer growth and profitability," he added. Outstanding opportunity for growth Desoisa said the Martin Currie Emerging Markets Fund has holdings in three of the most notable banks in the country, which are HDFC Bank , ICICI Bank and Kotak Mahindra Bank. Both HDFC and ICICI are in the portfolio's top 10 holdings, with allocations of 2.5% and 3.8%, respectively. Meanwhile, Kotak Mahindra accounts for about 1.6% of the portfolio. At the end of April, the fund had about $669 million in assets under management, with 52 holdings, as well as an overweight weighting on India. The Class A version of the fund has an expense ratio of 1.2%, according to Morningstar. For investors, two out of those three stocks are also listed in the U.S. The sponsored ADRs of HDFC Bank are down 0.8% this year, while ICICI's is 4.7% higher. HDB YTD mountain HDFC Bank YTD "They are three banks that are growing very quickly but are managing asset quality very well. And HDFC Bank and Kotak Mahindra Bank have had a long-term track record of managing their asset quality very well," said Desoisa, adding, "ICICI Bank had some issues in the past, but is now very much on an improving trajectory, and actually the level of profitability of that bank is now alongside the highest quality out there." The fund manager noted HDFC alone has 71 million customers, which is about the size of the population of California and Texas combined, but nevertheless a fraction of India's population. Desoisa said HDFC is adding about one million customers every month. Another factor that will drive growth for these firms is claiming greater market share from state-owned banks, especially as private firms such as HDFC invest more in technology. "Overall, the private banks in total have about a 40% market share. That has been increasing over time and we expect it to continue to increase year after year," Desoisa said. "So, the actual market opportunity is very under penetrated, but also, there's a huge market share opportunity as well for these private banks." Banks deserve a premium For investors, Indian bank stocks continue to be attractive because of their low nonperforming loans, steadily expanding loan activity, as well as high net interest margins, according to Glovista Investments' Carlos Asilis. A nonperforming loan is a loan that may not be paid by the borrower. "Different countries can claim their economy is going to grow a lot, but the reality is the consistency of Indian economic growth has been stronger than for most countries," Asilis said. "What that means is when they tell you their momentum on loan book growth is around the big teams, it's unlikely to surprise to the downside. That deserves a premium." Indian banks could help investors diversify their portfolios, as the banks have more straightforward balance sheets than their developed market counterparts. "If you look across emerging markets, there [are] no issues with their banking system," said Dina Ting, senior vice president and head of Global Index Portfolio Management at Franklin Templeton. "It's kind of the telling story of diversification. There's a lot more you can benefit by having exposure to international markets, because not everything is highly correlated. You do have a benefit of diversification from that angle," Ting added. Of course, there are other ways investors can gain access to the growth in India, including some single-country ETFs. In addition to the iShares MSCI India ETF (INDA), which is down 0.3% this year, there's also Wisdom Tree's India country ETF (EPI) , which is up nearly 2%. Meanwhile, there's iShares MSCI India Small-Cap ETF (SMIN) , which is up 2.8%. Franklin Templeton's FTSE India ETF (FLIN) is slightly higher. Here are the expense ratios for each of those funds: INDA: 0.64% EPI: 0.84% SMIN: 074% FLIN: 0.19% "For a majority of investors, accessing Indian locals [is] difficult because there are a lot of restrictions," Ting said. "Having an ETF that allows [an] investor with one single trade to get exposure to 70 plus different companies is a tool to kind of democratize access."