The long wait is over for HDFC Bank’s investors. Its foreign shareholding finally dropped below 55% at the end of June–albeit slightly, to 54.83%. This triggered a technical factor on the bank’s weight in the MSCI India Index.
Once HDFC’s foreign shareholding drops below 55%, its weight in the index doubles–though not immediately. The official announcement is expected on 13 August and the actual adjustment on 30 August.
To know why the 55% foreign shareholding is the magic number for HDFC, it’s important to understand MSCI’s weighting methodology. Under the company’s rules, the index assigns full weight to a company once the stock’s foreign shareholding drops below 75% of its foreign ownership limit.
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For HDFC Bank, 75% of the foreign ownership limit of 74% works out to 55%. So if HDFC Bank’s foreign shareholding is less than 55% it will have full weight on the index, but if it is 55% or higher, the weight drops to half. With the bank’s foreign shareholding now below 55%, its weight is expected to double from 4% to about 8%.
Investors seem to be excited about this technical milestone–HDFC Bank’s shares have been climbing over the past month. The bank’s foreign shareholding stood at 55.54% at the end of March and investors who had been hoping it would drop below 55% by the end of June saw their wish granted.
What does a higher weight mean? There are two categories of foreign funds–active and passive. Passive funds replicate the MSCI India Index, just like Nifty Index funds. Active funds use the index only as a benchmark, and their positions may be underweight or overweight on certain stocks. While passive funds will have to buy more if HDFC’s weight increases, active funds may or may not buy.
Active funds are in fact unlikely to buy HDFC Bank stock as their investments are driven primarily by financial performance. Following the unimpressive net interest margin and deposit growth in Q3 FY24, foreign institutional investors had reduced their stake in HDFC Bank to 47.8%, from 52.3% during the March quarter, dragging the stock down from its quarterly peak of ₹1,684 per share to a low of ₹1,364. Thus, the current stock price of ₹1,728 may not entice them.
In fact, the relative valuation of HDFC Bank is no longer appealing as some investors might have preemptively built positions in the stock, anticipating the weighting increase. Even after deducting the valuation of subsidiaries at ₹250 a share from the current market price, the bank’s stock is priced at 2.6 times the adjusted book value based on FY24 earnings, as compared to 3.1 times for ICICI Bank.
ICICI Bank’s superior return on assets for FY24 (2.4% against HDFC Bank’s 2%) deserves a valuation premium.
Over the past year, HDFC Bank’s shares have been flattish while ICICI Bank’s have returned 30%. It may be tempting to consider buying the underperforming stock, but investors should note that the discount to ICICI Bank’s valuation is likely to persist unless return ratios improve substantially.
For now, there are two important events to watch out for–HDFC’s Q1 FY25 earnings on 20 July and the Union Budget. Apart from these two critical events, the relative valuations of the two banks deserve more attention from investors than the ‘magic’ 55% number.
