The list of top performing equity funds for the past year features a couple of unusual entries. With a return of 18-21 per cent, CPSE ETF (managed by Nippon India Mutual Fund for the government of India) and the Bharat 22 ETF (managed by ICICI Prudential Mutual Fund) are top rankers among equity funds.
This has many investors asking if they should add these passive funds to their portfolio. The portfolios of CPSE and Bharat 22 ETFs are made up of the PSU oil, energy and financial giants which are the flavour of the season. These ETFs’ costs are ultra-low because they are used as divestment vehicles. Both ETFs would also seem to be ‘value buys’ if you go by their ultra-cheap valuations. The CPSE ETF trades at a portfolio PE of 7 times and Bharat 22 ETF at about 11 times. This is a fraction of the current Nifty50 PE at over 21 times.
But does this make them worth betting on? There are five good reasons for long-term stock investors to steer clear of these ETFs.
No unifying theme
Investors like to bet on thematic funds mainly because they can deliver outsized returns from concentrated exposures to a certain sector or theme. For instance, an infrastructure fund will own focussed exposures to road operators, EPC players, construction, cement, and capital goods firms (and perhaps banks which finance them). If the government announces a higher-than-expected capex outlay or infrastructure allocations in the Budget, one can expect this entire set of stocks to fire up and deliver outsized returns. Broader thematic funds like a manufacturing fund or a consumption fund, though they invest in diverse sectors, do have a cohesive theme that will perform if a certain macro thesis plays out.
Central PSUs in India are present across many unrelated sectors ranging from building construction (NBCC), to hydropower (NHPC), to oil and gas exploration (ONGC, Oil India), to finance (REC, PFC) and railway ticket booking (IRCTC). Of this diverse range of PSUs, stocks that figure high on the government’s divestment list, irrespective of their prospects or the sectors they hail from, are parked in these two ETFs.
This leads to a lack of a unifying theme in the CPSE ETF or Bharat 22 ETF. This results in investors bearing the risks of a concentrated portfolio, without its rewards. For instance, there’s no logic for why FMCG and bank stocks in the Bharat 22 ETF should move together, or for defence and energy stocks in the CPSE ETF to show correlated gains.
Both the CPSE ETF and Bharat 22 ETF were constituted because the Centre found it quite tough to garner a good market response for individual PSU disinvestment offers. Constructing a ‘portfolio’ of PSU companies helped to offer a diversified proposition to public investors, especially when the offers were sweetened with discounts to market price.
You should be buying a thematic fund because you believe that the stocks or sectors making up the theme are correlated to each other and will deliver concerted outperformance, if a particular thesis plays out. The CPSE and Bharat 22 ETF simply own sectors and stocks that their promoter (the government) is most keen to sell, with no macro thesis or cohesion backing them.
Ad-hoc stock selection
Thematic funds work because the fund manager makes conscious stock selection choices based on fundamentals, on which stocks to include to play the chosen theme and which to leave out. In ETFs, stocks with the largest market cap and highest free float within a select set of sectors are added to the index, while those that slip on these parameters are regularly weeded out.
But the composition of the CPSE and Bharat 22 ETF portfolios are not decided by a fund manager or index provider, but by the government of India deciding to add or drop a stock from its divestment list. This can lead to arbitrary changes, based on the shifting divestment agenda. The CPSE ETF’s portfolio has seen several rejigs since inception. Stocks such as PFC, REC, GAIL and Concor which figured in its initial portfolio no longer feature today, while BEL, Cochin Shipyard et al have made an entrance.
Here's a sampling of how the CPSE ETF portfolio has shifted over time.
The Bharat 22 portfolio has seen less churn. But in this case, private sector exposures in L&T, ITC and Axis Bank were added to the initial Bharat 22 portfolio because the government entity which bailed out UTI owned exposures to these three stocks, which were slated to be divested. Once the divestment is complete, these holdings may be shunted out and new ones added.
Unlike other ETFs, where stocks are usually removed when they underperform, stocks can ironically be moved out of government-run ETFs because of positive corporate actions. The NMDC stock was excluded from the CPSE ETF in June 2022, pushing up weights of ONGC, Coal India and Bharat Electronics. The provocation for this exclusion was that NMDC had announced the demerger of its steel unit, which is actually a value-accretive move for investors in the NMDC stock!
Fundamentals apart, liquidity plays a very important role in deciding stock returns in the long run. One reason why PSU stocks have been long-term underperformers in the Indian market has to do with their supply overhang. With their promoter (GOI) perpetually on the lookout for ‘favourable’ market conditions to offload its holdings, even fundamentally sound PSUs are dogged by a supply overhang that weighs on stock price performance. In fact, unlike private sector promoters who would look to dilute their holdings at peak valuations, divestment efforts by the government are often desperate attempts (at the fag end of the financial year) to stick to fiscal deficit targets.
Given that the primary purpose of the CPSE and Bharat 22 ETFs is to own divestment-worthy stocks in which the government owns over a 51% stake, the stocks in these indices are constantly pressured by the supply overhang. In fact, the promoter’s tendency to offload small stakes in ONGC, NTPC, Coal India and the like every fiscal is a key reason why these stocks trade at such rock-bottom valuations despite reasonable fundamentals.
Hazy divestment roadmap
Having tracked PSU stocks for a while, we’ve seen that there are a few standard narratives that power PSU stock outperformance from time to time. The ruling government’s resolve to adhere to ‘minimum government, maximum governance’. Its decision to identify ‘non-strategic’ sectors and get out of them. Its big-bang intent to privatise major PSUs by finding suitable ‘strategic buyers’ for its entire stake in certain PSUs. But despite successive governments making attempts to move forward on these resolutions, there’s been little progress on the ground.
In recent times, we’ve seen the ruling regime attempt strategic sales of well-run PSUs such as BPCL and Shipping Corporation, to no avail as private bidders have shied away. Even in a sector like banking where government presence is ubiquitous and there was a clear resolve to reduce the government equity stake below 51%, the Centre has been forced to shelve the idea on stiff resistance from trade unions and fear of losing depositor confidence.
In cases where the government has managed to surmount enormous hurdles to take a PSU behemoth public, as in the case of LIC, the pushback has been so strident that only minority stake sales have been possible. All these instances tend to demolish the hope that strategic sales, privatisation or ‘minimum government’ will one day lead to massive value unlocking across all PSU stocks.
Finally, a key reason why many seasoned investors stay away from PSU stocks, as a class, is that one can never predict what their promoter may do. (Check out this take by R Balakrishnan on PSU stocks)
Private sector promoters, for all their governance shenanigans, can mostly be counted upon to avoid moves that directly destroy the value of their stock. But the government, driven by social, political or altruistic motives, can announce regulatory or policy moves that directly destroy shareholder value in PSU stocks.
Annual demands for high dividend payouts and buyback offers have seen many a PSU behemoth including ONGC, NTPC and Coal India being stripped of the cash reserves that they badly need for their capex. Investors in IRCTC, among the better PSUs to own, have been subject to periodic jolts from the government waiving off or seeking a 50% share in its main revenue stream – the convenience fee on railway ticket booking. ONGC has seen a substantial PE derating after it was made to ‘acquire’ HPCL as part of a last-minute divestment manoeuvre by the Centre.
All this in fact goes to explain why PSU stocks trade at a significant discount to their private peers, even after this bull market has run on for over seven years. Despite their recent outperformance, the since-inception returns of the CPSE ETF and Bharat 22 ETF at about 9.5% CAGR, are far from impressive.
In fact, many of the above disadvantages of PSU stocks apply not just to the CPSE ETF or Bharat 22 ETF, but also to other passive and active funds tracking the PSU theme. In our view, there’s no compelling reason for any investor to own a clutch of PSUs just because they happen to have a common promoter. The best way to play these stocks is through a bottom-up approach that evaluates each company purely on its business fundamentals and sector prospects.