In a recently released report on the Indian banking sector, a leading FII states: "the markets have fully recognised and rewarded the proactive private sector banks for their initiatives to strengthen long-term competitiveness."

As a result, in the last one year, private banks like HDFC Bank and ICICI Bank have outperformed the Sensex by 230 per cent and 372 per cent respectively. In the same period, state-owned banks like BoB, Corporation Bank and State Bank of India showed underperformance of 49 per cent, 11 per cent and 21 per cent to the Sensex respectively.

These banks, which were "severely punished" for most of the year, have outperformed the market in the last three months in a falling market. So BoB, Corporation Bank and SBI showed relative price growth of 11 per cent, 30 per cent and 20 per cent respectively.

"Current valuations of private sector banks are stretched, leaving very little room for further upside," points out the FII research report. It adds that for HDFC Bank and ICICI Bank, the market price adequately discounts their expected compound annual growth rates (CAGR) of over 50 per cent in earnings in the next three years. Among the state-owned banks, SBI is "close to its peak valuation, as return on equity is expected to be well below the cost of equity over the next two years."

On the other hand, both BoB and Corporation Bank are trading "well below their fair values", claims the report. BoB, in particular, looks extremely cheap at 0.4 times its one-year forward book value and "is trading at a dividend yield of 10 per cent," says the report.

The FII report maintains that the "derating of BoB is overdone, particularly in view of the reasonable 11 per cent earnings growth over 2000-2002 against just 2 per cent earnings growth forecast for SBI."In view of their strong earning growth potential and their current depressed valuations, the FII analyst feels that both BoB and Corporation Bank offer good appreciation prospects for investors with a one-year time horizon.