Editor’s note: We are starting something new today! We are going to be sourcing, by invitation, top-quality financial research and analysis content from renowned experts in the field for you. We are proud and happy to start this endeavour off with an article on PSU stocks by R Balakrishnan, a fiercely independent thinker and writer about all things finance.
Balakrishnan (or Bala as he is known popularly) has had a fruitful innings that covers banking, finance, industry, capital markets and credit rating. He is one of the founding team members of CRISIL and before that has worked in finance and banking. After CRISIL, he shifted to capital markets. He was head of research as DSP Financial Consultants Ltd. He then spent time in various consulting assignments and had a brief stint in the mutual fund industry as CIO and CEO of First India Mutual Fund. He writes on investment and other things that catch his eye.
There are more than sixty Public Sector Undertakings (PSUs), seventeen Public Sector Banks (PSBs) and around a dozen State owned undertakings, that are listed on the exchanges. A couple of days ago, some mutual fund managers raised a desperate shout to the government about the ‘non-performance’ of the shares in these undertakings. To me, this raises a bigger issue. Why should one invest in any PSU stock? Is it value? Is it growth? And if there is value, can it be unlocked? The conundrum? I see value, but I do not see the prices.
PSUs such as SAIL, BSNL and MTNL were created at a time when the private sector either did not have the capital, or could not be trusted with a sector perceived to be of national importance. Many PSUs were created by acquisition and nationalization too – oil companies, PSU banks, insurance companies, Air India, National Textile Corporation to cite a few. At some stage, the private sector also entered the fray, but the promoter was loath to let go of these businesses – BSNL, MTNL, SAIL, Coal India and Air India are living proof. The socialistic leanings of successive governments acted as a deterrent and there were vested interests that would lose fiefdoms if the PSUs were privatized. Even now, PSU banks are majority government-owned despite many committees recommending their divestiture.
# 1 The profits of just ten companies out of 274 accounted for nearly two-thirds of the entire profits of the PSU universe.
# 2 PSUs in cyclical or commodity businesses cannot be valued like their private sector peers as they have a lot of social baggage
# 3 Whenever there is a regime change or a budget, theories of how one group of PSUs are going to be favoured with a lot of business start doing the rounds.
# 4 To me, PSUs are speculative or trading opportunities
All governments come in with a promise of change and the more they promise, the more things remain the same. Crony capitalism decides policies when it comes to holding on to or selling off of PSUs. And the timing of these sell-offs if they happen, is always poor, this promoter does not seem to realise that it is a custodian of public wealth. Yes, these companies are large and many enjoy monopolies. Management quality comes to the fore. Age-long monopolies should have translated into profitable money-making machines. In reality though, we have nearly bankrupt monopolies like BSNL and Air India.
When the PSUs were given shape, the logic was that industries that need large capital and have a long gestation period, need to be fostered by the government. The second argument was that the government ought to have a hand in sectors of ‘strategic’ importance like defense, essential items etc.
But at an aggregate level, the PSUs have been a drain on critical resources for the government. The return on the capital invested from these firms has been sub-par. The government had invested a total of Rs.16,40,62,792 crore in 274 enterprises as of March 2019. The aggregate profits were Rs. 1,25,47,976 crore. Of the profits, nearly 72,000 crore was paid out as dividend. This is a return of around 7.6 percent. This is after many years of being around. So, we seem to be dealing with a promoter whose return metrics are perhaps very different from what the private sector and the stock markets use.
There is a very interesting publication titled “Public Enterprises Survey”. The last one I could access was for the financial year 2018-19. The financial summaries of each company are highlighted in it and this is a useful reference point for understanding and analysis of PSUs. One striking metric in this report is the profit situation of PSEs: The profits of just ten companies out of 274 accounted for nearly two-thirds of the entire profits of the PSU universe. Clearly, all is not well with many of the businesses run by this promoter.
Now, let me turn focus to the listed universe. Should one invest? If yes, is there a strategy or a possible method?
The first rule of investing in PSUs is that one must have unlimited patience, waiting for the stock to be either a multi-bagger or go to zero. Or one must use the reverse-trade strategy, with a financial stop-loss. The disadvantage with this is that stocks could be range-bound for a long time. One therefore needs to club it with a holding period limit of say six months. If you do not hit the stop loss and the stock has not gone anywhere in six months, it may be wise to get out of the trade.
As an investor, I will probably divide PSU stocks into a few groups:
- Smokestack PSUs- Commodity produce, global prices, business cycles and inefficiencies of cost and scale built in. These companies cannot be valued like the private sector. There is political intervention in pricing. Tariff structures are designed more to suit private sector than public. PSUs have a high capital cost, have a lot of ‘social’ baggage (employee housing, union labour, over staffing) and inflexibility in shedding both employees and costs. In addition, there are possibilities of graft in buying and selling. All of these factors combine to deliver a lower ROCE than the private sector, even with factories built decades ago, at rupee costs that were nominally far lower, adjusted for inflation. There are many companies, like BHEL for instance, that run at low capacities but do not even think of cutting costs or people.
For such PSUs, there is a history of big mood swings on valuation. I would like to use Price to Book as the basis for valuation. The P/BV will tend to be far lower than that of the private sector peers – partly because of lower ROCE and partly due to the promoter factor. One characteristic common to all PSE stocks is that there is no dominant “operator” which most private sector stocks seem to have.
These stocks I buy if the market conditions are normal (not in these pandemic times) and the prices are close to historic lows based on P/BV. I hope for a reversion to mean.
- New-age (Post 1991) PSUs. Many of the PSUs set up post 1991 are better structured than the Nehruvian era ones. Companies like Concor, Engineers India and RITES are aggressive companies. Yes, they lack the hunger for business and profits that the private sector has. But they are profitable and seek growth. Leadership is of course an issue, with the promoter choosing leadership from bureaucracy rather than from industry. They have all the administrative and structural problems of the old age PSUs but are seen to be more competitive.
For these, I will use earnings as the valuation anchor. Where there are natural monopolies, like IRTC (not that it is sacrosanct), growth is the element that drives valuation. The buying trigger here has to be something like an earnings surprise on the downside or news flow that brings the price crashing.
- New narratives – I find this to be a recurring theme. Whenever there is a regime change or a budget, theories of how one group of PSUs are going to be favoured with a lot of business start doing the rounds. I have seen these stories for thirty plus years. I will believe them when they actually materialise. Defence contracts, railway wagons, infrastructure push are the typical thematic narratives that drive stocks, or there’s always ‘de-regulation’ and ‘de-control’. I will ignore such sure-shot opportunities. I would know when to buy, but then no one tells me when to get out. These are speculative opportunities in the extreme.
- Window-dressing props – Some PSUs undertake businesses which make no commercial sense. For example, financing structures created to fund power plants or the bankrupt State Electricity Boards which remind one of a Ponzi. (PFC is a great example). You keep on funding SEBs until a part of the core capital is permanently stuck in receivables. Then to fix this problem, the government comes out with more such schemes and creates more enterprises. Given that Book Value is an accepted matrix for the finance business, PSU financiers lag the private sector. There is an evergreening of receivables without any such mention. As an investor, I am not a buyer of these kind of stocks. These organisations constantly keep raising debt and the debt gets easily placed because of promoter being a sovereign. These organisations are capital-hungry and their promoter is hungry for dividend., a conflict no one wins.
- PSU Banks – There’s a story brewing here. Having cleaned up PSU banks somewhat, there is now some thought of ‘privatising’ a handful of banks. To the buyer, it is going to be a bargain. Most of the PSU banks have a network that has taken ages to build. Legacy issues like staff etc can be dealt with in a matter of time. Unions can be handled. If there is good management (People argue that only Kotak/HDFC/Indusind have turned up clean from the new generation) there is a fortune waiting out there. These investments need two things- patience and luck. Patience to buy, wait for the new management to bolster the profitability of an established bank with a readymade network, deposit base and business spread. But luck is also critical. Of the five or six that will be given to private hands there is a fifty percent probability that what you pick will be bad. There is a small probability that one of them could be another HDFC or Kotak. Luck plays an important part in your choice.
As an investor, is it important to have PSU stocks in the portfolio? For me, PSUs are trading or speculative opportunities. I do not like the promoter. His capital allocation is poor. A company like GAIL could have been a pure pipeline company. It was saddled with the burden of subsidies and also used its cash flows to invest into refineries. These moves killed the valuation of GAIL. So I would like to see an ownership change, before I consider these stocks as investible opportunities.