Indian banks may be closer to a re-rating than their recent performance suggests. Bank of India Mutual Fund CIO Alok Singh says lenders have the fundamentals investors typically look for—low non-performing assets, healthy return on assets and equity, and loan growth—but lingering concerns over net interest margins and FCNR-related liquidity flows have kept the trade from taking off.

That overhang could ease as policy announcements emerge and banks disclose stronger business numbers, Singh said in an interview.

Public- and private-sector banks are fairly valued and have become cheaper since last quarter, even as their underlying businesses continue to perform well. “The consensus trade just hasn’t come through yet,” he said, adding that this disconnect cannot persist indefinitely if the operating trend holds.

Edited excerpts from a chat:

Congratulations on the wonderful performance of your smallcap fund. Everybody these days is talking about small and mid caps, but the smallcap benchmark itself hasn’t moved much in the last one year — just 4-5%. So there must be a lot of stock-picking opportunities in the fund?

Small-cap is a large space with a large number of stocks. Even the Small Cap 250 index is only 250 stocks. If you look at stocks above ₹1,000 crore market cap, there are roughly 1,450-1,500 of them. Remove the top 250 (or even top 500), and there are still 900+ stocks left — so it’s a much bigger universe.

As the market and economy normalise, not everything does well — some things do well, some don’t — so bottoms-up stock selection becomes more important. Post-COVID, the entire small-cap space benefited from re-rating, so stock picking mattered, but simple allocation to the space also worked as long as you were exposed. I think this is the first time we’re looking at a truly normalised economy — even the government has chosen 2024 as its base year, implying normalisation happened after that. This is getting reflected in portfolios: if you’re not in the right stocks, you won’t participate as much.

How much of your portfolio goes beyond the Small Cap 250 index?

We have always run a bottoms-up portfolio and use the benchmark more for risk management than for portfolio construction. That said, while we look at all stocks above ₹1,000 crore market cap, it’s not that we only look beyond the top 250. My portfolio’s average market cap is around ₹24,000 crore, and the weighted average is around ₹25,000 crore. There is hardly any large-cap exposure — maybe 2-3%. So it’s predominantly a small-cap portfolio with some mid-cap. It’s not about concentrating in one place — it’s about finding where newer pools of profit are being generated and building the portfolio around that.

Purely from a market-cap perspective, is there a “sweet spot” you hunt in — say, ₹10,000-20,000 crore?

No, we don’t look at it from a market-cap point of view — we look at it from a business point of view. We’re not “growth hungry” either; across our portfolio we buy anything that makes sense on a relative basis, whether that’s value or growth. If you’re buying value, there has to be some change or inflection point happening, otherwise the value doesn’t get unlocked — growth similarly doesn’t sustain without an inflection point.

In one line: we look at things on a relative basis. If something makes sense relatively, we’re okay looking at it — whether it’s a ₹5,000 crore, ₹10,000 crore, ₹20,000 crore, or even ₹50,000 crore market cap company. That’s not how we approach it.

So once an idea makes sense, allocation becomes key?

Yes — and that’s where we believe the real differentiation lies. Everyone stresses finding new ideas, but what you do with an idea is equally important. No idea stays exclusive to you for long, because in the mutual fund world, once you buy something and your monthly portfolio is published, the whole market knows what you’ve bought — even without doing the fundamental work themselves, others can reverse-engineer why. So finding a good, scalable business or one going through a transformation is only one part. How you size it and scale it up in the portfolio is most important — especially for us, since we don’t run either very concentrated or very spread-out portfolios.

You currently have around 90 stocks in the portfolio. Tell us about your position sizing and churn.

Yes, right now it’s around that, but we like to run 70-80 stocks and may moderate it — it’s a bit of a transition period currently. Since the fund launched in 2018, we’ve generally run a 70-80 stock portfolio, and that’s where we wish to stay on a long-term basis. Sometimes the number ticks up a bit due to a few transitional additions. In terms of position sizing, 3-4% is the highest we buy.

Because we run about 90 stocks, there is naturally some churn happening — something is going in or out, which is why the stock count and turnover sometimes rise. But we don’t do a clean, sharp exit from any stock unless there’s a specific reason for concern. On a long-term, steady-state basis, turnover would be more like 0.65-0.7x.

Within small and mid-cap, where do you currently see both growth and valuations that aren’t excessive — i.e., no euphoria?

Frankly, after the last 3-4 months’ up-move in mid and small caps, I don’t see any pockets that are screamingly undervalued. The market looks fairly valued to me right now — wherever you see slightly above-mean multiples, those are being driven by the earnings those stocks are delivering. So across small, mid, or even large cap, the market seems fairly priced in terms of multiples. That means any further movement has to be driven more by earnings, which is why there’s some nervousness — earnings depend on visualisation and assumptions around execution, which people may or may not agree on.

On a steady-state basis, though, the market appears fairly priced. That’s why markets have largely gone sideways over the last month or so. Going forward, I believe earnings will play a bigger role in shaping the market than further multiple re-rating.

Q1 earnings were very good, Q2 is also expected to be good, but the concern is Q3 onward — especially in pockets affected by GST and income tax rate cuts. Is that a worry?

The base effect will play a role, but if you look at GST collections, we’ve actually surpassed prior levels — so collecting more GST at a lower rate, with goods and services volumes unchanged, means volumes have actually picked up. So I don’t think the base effect will be a major issue.

One thing to appreciate: markets were surprised by Q1 earnings because, when the Middle East crisis happened, the consensus was that Q1 would take most of the hit and Q2 onward would see recovery, normalizing in the second half. As we analyzed results, we realised the impact wasn’t concentrated in April but more in the May-July window, due to low-cost inventories and similar factors — so there will be some spillover into Q2 as well, which wasn’t the earlier consensus. That’s adding to market nervousness, since there’s now uncertainty about whether the impact ran through June, July, or even August.

That said, I don’t believe the impact goes beyond Q2 — which also has its own seasonality with Diwali falling a month later this year. Adjusting for these factors, I think earnings should actually be better, because high-frequency demand indicators — vehicular traffic, power demand, GST collections, toll collections, passenger traffic — are all suggesting decent buoyancy in the economy. If that continues into the festive season, the season should be good, since festive spending typically follows a build-up rather than appearing suddenly. Overall, I think external disruptions (freight movement, transit times, buyer-seller reconciliation) have now normalised and shouldn’t be a surprise element unless something changes from here.

Can you get more sector-specific on where you expect strong earnings momentum over the next couple of quarters?

The capital goods space — specifically industrial automation, industrial products, power equipment — is seeing a good tailwind from both domestic and global demand, and I expect that to continue. Precision engineering, part of capital goods, is also seeing decent order flows.

On BFSI, I think banks at large should do well. Earlier there were concerns about NIMs (going back to Q4 of last year), and now there’s some worry about FCNR-related spillover effects. But I don’t think liquidity pressure is as large as the market anticipates — RBI has repeatedly tried to suck out excess liquidity, and even a recent ₹7 lakh crore reverse repo saw limited takers. If liquidity were truly excessive and suppressing NIMs long-term, banks wouldn’t be holding it back from RBI — any reasonable treasury head would rather place it with the RBI than sit on it. That tells me it’s transitory — CBLO might dip to 2-3% for a few weeks, but that’s not permanent. So banking should be another sector that does well.

In the broader segment, capital goods and banking look okay to me. In a smaller segment, metals look good given demand and government policy, with decent capacity utilisation — not a large weight in the index, but earnings growth there looks decent. Elsewhere: pharma is mixed — some doing okay, some facing issues; FMCG faces margin and inflation pressure; consumer durables — some are doing fine; auto is doing okay but fairly priced, so while we stay positive, I don’t see a major surprise element there since the earnings are largely already discounted.

Among these sectors, do banks have the higher chance of re-rating if earnings pick up?

Yes. A large part of large-cap underperformance has come from IT, but banks also haven’t done the “heavy lifting” they should have, given their index weight and valuations. Whichever way you look at it — public or private — banks are fairly priced, and all the boxes that should tick for a bank are ticking: low NPAs, decent ROAs leading to decent ROEs, and loan growth. The consensus trade just hasn’t come through yet because of lingering worries about NIM pressure and possible rate moves. As policy announcements come through over the next few weeks, I think this will reconcile. Business-wise, most banks are doing well and have gotten cheaper since last quarter without the market reacting — but that can’t continue indefinitely if the trend persists.

Credit growth wasn’t a problem for banks anyways, and now deposits are also coming back via FCNR. So both sides of the balance sheet are sorted?

Correct. Banks running high CD ratios will be able to access liquidity now. Also, some NBFCs benefit indirectly — as pressure on larger banks to raise deposits eases, and money needs to be deployed, one avenue is lending to NBFCs. It may not offer the best spread, but it avoids negative carry. So NBFCs become an indirect beneficiary of FCNR flows too. I think the FCNR-related NIM-pressure overhang that the market is pricing in won’t be as large as feared, and as banks disclose business numbers, there should be a positive surprise.

Crude has again crossed $100, and there have already been about $1.5 billion of outflows this month, with the rupee under pressure — the macro setup is weakening this month. How much of a worry is the Middle East tension?

Obviously oil has an overhang on us — there are two sides: the inflation side and the availability side. Availability is the bigger question; every time there’s escalation, the possibility of supply being cut increases. The market is more worried about a potential availability cut than about the price level of $100 or $110 per se, because a higher price only impacts margins, whereas zero oil availability means no margin at all.

That said, yes, $100 or thereabouts does affect inflation and could have a broader margin impact via the Reserve Bank’s response. It’s a very hot-and-cold situation, so it’s difficult to take a decisive view. If it sustains at these levels for a longer period, we’d need to be more worried — but I’m not worried about it today. If there is an actual sustained supply-side issue, that concerns me more than the price being $100 or $110, because economies will adjust to price; there could be some disruption here and there, but on the whole we’d be okay. Non-availability is a bigger issue to me than $100 oil.