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Foreign investors are buying into Indian financial firms, lured by the prospects of a fresh credit cycle that may boost the stocks of the country's largest lenders.

Indian shares are trading at a record-high valuation premium to their Asian counterparts, BNP Paribas said, but overseas investors have found a bright spot in financials, considering them relatively cheap given their strong fundamentals.

The optimism is reflected in inflows, with foreign investors buying a net of $1.74 billion worth of Indian financial stocks in November, data released by the National Securities Depository Ltd this week showed.

That is more than a third of the total $4.44 billion net inflows for the month.

"PALATABLE" VALUATION

Indian financial stocks are trading at a premium to their historical average, but that is not necessarily the comparison investors are looking at.

"As a foreign investor, when you're comparing valuations across India, financials look more reasonably valued than some of the other sectors," said Rob Brewis, fund manager at UK-based Aubrey Capital Management.

Paying double-digit multiples for consumer banks such as HDFC Bank Ltd or ICICI Bank Ltd "is much more palatable," said Brewis, as the potential for lending growth in India "is probably better than almost anywhere else in emerging markets."

All the six fund managers that Reuters spoke to were optimistic about a fresh capex cycle in India, fuelled by the government's infrastructure investments.

This growth cycle coincides with banks' boasting the cleanest balance sheets in the past five-six years and average corporate leverage at a decade low, Manishi Raychaudhuri, head of equity research, Asia Pacific at BNP Paribas wrote in a note.

India is touted to be among the world's fastest-growing economies and corporate earnings growth is expected to be among the strongest in Asia. This has prompted local and foreign investors to pour money into the domestic equity markets, which hit all-time highs last week.

Given the improved macro outlook and continued investments by financial firms, especially larger private sector banks, to improve their franchise and process capabilities, private banks are well-positioned to continue to gain market share, said Sukumar Rajah, director of portfolio management, Franklin Templeton EM Equity.

"Even post the recent rally, we still see some scope for further re-rating in select names."

The optimism comes despite financial stocks trading at a premium to their two-year historical average on a price-to-book valuation basis.

CHINA RISK TO PREMIUM VALUATION

The valuation of Indian equities has always been comparatively lofty, to account for the growth potential, but the disparity with emerging market peers has widened this year due to a heavy sell-off in other countries.

While India's benchmark stock index has risen 7.3% so far this year, stocks in China, South Korea and Taiwan have fallen between 12% and 19%.

But that may not continue.

"In the face of rising external risks, it's difficult to see India continuing this level of valuation premium over other markets," said Sat Duhra, Asia equities portfolio manager at Janus Henderson Investors.

A major risk, Duhra said, was a sustained rebound in China due to relaxations in its zero-COVID policy, given India has been a beneficiary of China's falling share in emerging market indexes.

Monthly flows into Indian financial stocks so far this year

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Indian stocks compared PE