PSU Stocks: ‘Deep Value’ Or Value Trap?
The ratio of the MSCI World Value Index versus MSCI World Growth Index is at a multi-year low. This suggests that investors in markets across the world are averse to buying value at this juncture and are keener to buy growth. I reckon if there was a chart for a similar index in India, it would probably show the same trend.
Value is out of fashion. The question is, for how long?
Meanwhile, there is a lot of talk about ‘deep value’ in a pocket of India’s stock market. Several brokerages, mutual fund houses, and portfolio managers are speaking of investing in ‘deep-value’ public sector units, on a bottom-up basis.
"One way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while still difficult to quantify, will usually take care of itself," said noted U.S. hedge fund manager Joel Greenblatt. I was reminded of Greenblatt’s comments after listening to an argument made by a PSU bull. What does one have to lose from investing in certain large PSU stocks, he asked? The argument goes along these lines:
- A large oil and gas major in India is the cheapest exploration and production stock in the world, as per CLSA.
- India’s largest power company is available at the highest dividend yield that it has ever been at.
- The market cap gains of newly-listed public sector companies like IRCTC, and the defence PSU Mishra Dhatu Nigam, or MIDHANI, and some others have shown that the right business model finds takers, irrespective of whether the owner is government or private.
Smaller PSUs, with the right business model and low float, are creating wealth for shareholders and the PSU bulls hope that if business improves and some technical headwinds ease, then maybe the larger ones too may find favour.
Supply Glut To Ease?
First to that technical overhang—the Central Public Sector Enterprises Exchange Traded Fund or CPSE ETF. Consistent selling by the government has meant that the market is always wary of additional supply pressure coming in.
The question to ask here is this—with the level of shareholding that the government is left with, in various PSU companies, can one take a bet that aside from strategic divestment, there won’t be substantial additional sale into the secondary markets by the government over the longer term?
With the latest tranche of the CPSE ETF that closed in January, the government stake in companies like NTPC and Power Grid is close to 51 percent, from which further non-strategic sale seems unlikely. For PSUs like Coal India and ONGC, where the government shareholding is still significantly higher than 51 percent, an offer for sale may well be the government’s preferred route since it can be done in tranches (to manage supply pressures) and can be done overnight (to avoid price destruction while the process is on).
Could the PSU companies put together an operational performance that offers a trigger or two of their own?
- While NTPC is available at attractive dividend yield, can it deliver on expectations of expanding return on equity and higher profitability over the next two-three years?
- Coal India is expected to show volume growth of 5-6 percent in FY21. Analysts believe weakness in e-auction realisations for FY21 could be offset by strong availability due to higher production.
- Smaller PSUs like IRCTC, ITI, MIDHANI have given a strong outlook for the year ahead too.
While brokerages are mixed in their views, there is the trend of mentioning valuation comfort across some of the larger names.
NTPC has a return potential of 39 percent, according to consensus on the Bloomberg Terminal. CLSA says “2020 is likely to be a year of focus on emission reduction at power utility NTPC, improving its ESG score and benefiting investors as the company creates expected 14 percent growth in regulated equity (RE) over FY20-23CL. The stock can outperform in 2020 as it has robust RE growth, which should expand its ROE 190 basis points over FY20-22CL, a rerating catalyst.”
ONGC is available at a price-to-earnings multiple which a 10-year low, and at over 7.5 percent dividend yield. A JP Morgan note on Feb. 12 alluded to this view on value as well, saying “Admittedly, ESG, government ownership, and stake sale are issues, but a 6x PE stock trading at 10 percent dividend yield with net cash at +25 percent of market cap is Value”.
Similar notes have been put out for companies like Coal India as well, speaking of volume growth and attractive dividend yield.
But Keep In Mind...
Not all public sector companies are showing the promise of growth. Brokerage notes on BHEL, for example, have dire warnings, with some saying that serious changes are needed to keep it a going concern. Meanwhile, the analysts at Macquarie believe that new forms of stress are emerging for public sector banks, and they have cut earnings forecast, lower than the street average by almost 30 percent. Trying to catch a falling knife over the last five years for a clutch of PSU stocks has proven to be a foolhardy move, with most large ones destroying investor wealth.
A cautionary voice comes from BloombergQuint columnist Saurabh Mukherkea who believes that PSUs’ “serial under-performance” is not just due to weaker financial fundamentals, but also because the government is not only the owner, but also the primary customer for many PSUs, which “puts at risk the efficient use of capital”.
The question is, can value realise into true value and not end up as a value trap? Should investors bite into the valuation argument or leave it out in the cold? 2020 certainly promises to be an interesting year.
Niraj Shah is Markets Editor at BloombergQuint.