The Efficient Market Hypothesis posits that all stocks always reflect all available information in their prices, making it impossible to find or buy undervalued stocks. With stock selection being redundant, the one way to increase portfolio returns is to increase systemic risk – i.e. buying high-beta stocks. Many distinguished investors, including Warren Buffett have torn apart the very foundations of EMH. Called ‘Superinvestors’ by Buffett, these all have been successful proponents of the value investing strategy – the assumption that markets are not efficient and there are opportunities in finding and buying stocks that are undervalued.
In the Indian context, there is a group of stocks that that has consistently flummoxed followers of the EMH as well as of investing. These are stocks of Indian public sector units. Say, for example, you bought State Bank of India, a stock with a relatively high beta of 1.3 in 2010. What would be your 10-year return? A CAGR of just 7.3 percent. If on the other hand, you tried applying investing principles and picked a ‘low’ price-to-earnings multiple stock like ONGC (11.5x P/E), you would have lost money in absolute terms over a 10-year period.
For many practitioners of investing, the quest for finding underd bargains often leads to stocks that look optically inexpensive – that is stocks with ‘low’ price-to-earnings ratio, price-to-book or enterprise to Ebitda multiples.
Relying on such multiples, however, has two hazards –
- The extent to which one can trust reported accounting earnings (the ‘E’ in the ratio); and
- The inability of these multiples to appropriately factor in the longevity of the underlying earnings.
However, a ‘low’ multiple stock is a temptation that’s hard to resist for someone in the hunt of an underd stock that will deliver superior long-term returns.
A common refrain you’ll hear is “What’s to lose in a 6x P/E stock”? In some cases, the answer to the above question is – “A lot”.
The P/E erosion of PSU stocks shows up starkly in their share price performance. As of Jan. 31, 2020, 7.6 percent of the Nifty comprised of PSU stocks. A decade ago, the corresponding ratio was 13.4 percent. If a decade ago, you had invested Rs 100 in the nine PSU stocks in the Nifty (assume 100 is spread equally across the 9 stocks), on Jan. 31, 2020, you would have Rs 163 in your hand including reinvested dividends. That equates to an annual rate of return of 5 percent. Over the same period, the Nifty returned a CAGR of 10.7 percent.
So why are PSU stocks serial underperformers? The usual answers to relatively weaker financial fundamentals of PSUs include ‘public sector inefficiency’ or ‘constraints of working under the 3 Cs – CAG, CVC and Courts’. A key reason, however, is that as minority shareholders, investors play on an uneven field with the government on the other side as a dominant shareholder as also as a customer of these PSUs. This duality of the government’s role puts at risk the efficient use of capital by PSUs, as well as the longevity of their earnings, which then reflect in the low multiples.
Government As Dominant Shareholder
In the last few years, the government has hit upon a novel way of disinvestment. Instead of offering its stake in PSUs to external financial or strategic investors, the government has forced a merger of two PSUs or the acquisition of one by another. This transfers the cash reserves of the buying PSU to the government, without diluting its effective control over the selling PSU. The poor minority shareholders end up indirectly owning businesses they may have no interest in. For example, NTPC is set to acquire the government’s stake in two hydropower entities for approximately Rs 10,000 crore. These acquisitions will see NTPC’s hydropower generating capacity increasing materially from the current ~1.5 percent. This significantly transforms the risk profile of the business, but minority shareholders hardly have any say in it.
A similar case played out in ONGC’s acquisition of the government’s stake in HPCL in January 2018. While this made the government richer by Rs 36,900 crore, minority shareholders in ONGC saw their stock price slide steadily – now 50 percent lower since the acquisition. There, of course, are other reasons also for ONGC’s poor stock price performance.
And that is why the stock trades at a ‘cheap’ valuation of just 5x P/E. NTPC also appears ‘attractively d’ at about 1x P/BV, but it is so because of the risk of the dominant shareholder continuing to influence poor capital allocation decisions on the management and/or compromising the company’s longer-term earnings sustainability.
Government As A Customer
In many industries, the government is a major or in some cases, the only buyer of a PSU’s products. Let’s take the example of defence PSUs such as Hindustan Aeronautics, Bharat Dynamics etc., where the Ministry of Defence is the only domestic customer. As a customer, the MoD wants to procure defence equipment at the best or lowest possible cost and as the dominant shareholder, it would desire to sell at the highest possible price. The conflict is not serious where a DPSU is 100 percent owned by the Ministry but becomes a cause of concern where there are minority shareholders.
In such cases, the Ministry, as a customer, can reduce pricing/profitability for the PSUs, but as a shareholder, it would escape bearing the entire brunt of the reduced profitability. This is what happened in September 2018, when the MoD reduced the margins on equipment procured from DPSUs on nomination basis. While the government gained from lower procurement costs on all future purchases, investors in a leading DPSU lost 33 percent of their wealth in a three-week period from the reduced margin norms becoming known.
These issues beg the question: should PSUs where such conflicts are likely to arise be listed at all?
The government believes, and rightly so, that listing increases market scrutiny and makes PSUs more accountable and hence, more efficient. But experience with many listed PSUs shows that is not always the case.
The alternative is to sell 100 percent of the government stake and permanently separate the unified customer/supplier set up. However, privatisation in India has multiple political angles rather than just plain economic ones and one can’t be sure how aggressively any government in power will take this path.
A possible way, then, to resolve the conflict of interest is to separate the ownership and procurement functions within the government. The government can create a separate Ministry of PSUs to act on behalf of the shareholders, that has a mandate to maximise profitability for all PSUs it is responsible for. Such a mandate would mean that procurement rules favour the supplier with the best possible price/quality/delivery balance, irrespective of whether it’s a PSU or a private sector company. This will also mean that shareholders have a representative to resist any attempts at corporate actions that impact earnings or put balance sheets at risk.
While rules already exist for competitive procurement across government departments, the separation of responsibilities would mean these rules are effectively implemented.
An added advantage of such a separation is that it helps level the playing field for the private sector to compete in government contracts, especially in case of ministries where a separate policymaking or regulatory body does not exist.
So, if the urban development ministry wants to redevelop government properties, it need not be done by a PSU under the ministry’s control, but by any agency with the most competitive project delivery capabilities.
What is the likelihood this measure helps achieve resolution of the conflict of interest, considering that ownership and procurement continue to remain with the government, even if under separate operational ministries? The answer to this lies in the history of disinvestment in the country. The disinvestment program saw success only after the decision and execution of the same were vested in a separate Ministry of Disinvestment and not with the ministry in charge of the PSU. Today, a separate department under the Ministry of Finance decides what, when and how to divest.
Separation of ownership from the functional ministry has the potential to improve efficiencies in PSUs and benefit all shareholders – the government as well as minorities.
However, there is a practical problem with the remedy mooted above – if you separate the ownership of the PSU from the functional ministry, you effectively reduce the scope for rent-seeking and patronage available to the said ministry. This obviously is likely to be resisted by the powers that be in that ministry. And hence it is hard to see how government-owned entities will ever break free of the bind laid out above. That, in turn, makes it all but certain that PSU stocks will continue to be serial underperformers. In effect, they are caught between two masters – the sovereign on the one hand and the demanding minority shareholder on the other. Arguably, that conflict of interest undermines their ability to serve either masterfully. The cheap multiples mask this crucial aspect of investing in PSU stocks. On a broader note, the inability to capture such dynamics is what results in the traditional format of investing also serially underperforming in India.
Saurabh Mukherjea is Chief Investment Officer, and Salil Desai is Portfolio Counsellor, at Marcellus Investment Managers.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.
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