Will the PSU bulls return?

Most PSUs belong to cyclical sectors such as banking, industrial, energy, mining, power, logistics, infrastructure and manufacturing. Their prospects are tied closely with that of the Indian economy.

Jun 15, 2021 01:06 IST India Infoline News Service

Public Sector Undertaking (PSU) stocks have witnessed a strong run over the past one year. S&P BSE PSU index has surged 66% versus a 56% growth in the S&P BSE Sensex. Government’s continued focus on disinvestment is a prominent factor behind this rally. Investors, though should remember that this growth comes on a low base of the preceding year. Between June 2019 and June 2020, the S&P BSE PSU index declined by 38%, underperforming the S&P BSE Sensex (down 16%) index by a huge margin.

PSU stocks have been under pressure post the pandemic, as it affected their business and profitability. Take the case of PSU banks, for instance. These banks were already struggling with the problem of mounting bad debts, which escalated further post the pandemic. The slowing credit offtake made matters worse for these banks. As per data from the Reserve Bank of India (RBI), year-on-year loan growth for PSU banks stood at 3.6% in the quarter ended March 2021, as compared to 9.1% for their counterparts in the private sector. This was the lowest growth over the past 13 quarters for the PSU banks. In fact, market share of PSU banks has dropped to 58% in FY20 from 75% in FY10, and this trend is likely to continue. However, privatization of the PSU banks could help put them back on the path of growth. After three rounds of consolidation in a row, the government plans to privatize another couple of PSU banks in FY22. Number of PSU banks in India has reduced to 12 in 2020, from 27 in 2017.

Recovery in stocks reflect expectations of economic revival

Most PSUs belong to cyclical sectors such as banking, industrial, energy, mining, power, logistics, infrastructure and manufacturing. Their prospects are tied closely with that of the Indian economy. Impact of the second wave of the pandemic has been less severe than the first one, given that several states implemented partial lockdowns this time around. As per RBI estimates, Indian economy is likely to grow by 9.5% in FY22. Benign interest rates and pickup in overall demand will aid prospects of state-owned companies.

Valuations at undemanding levels

We have witnessed multi-year growth in the market capitalization of PSUs between 2003 to 2010. During this time, the S&P BSE PSU index saw a CAGR growth of 29.35%, outperforming the Sensex, which gave a CAGR return of 26.43%. In other words, market capitalization of S&P BSE PSU index surged 6x in this time frame as compared to 5x growth in the Sensex. While the 30-stock benchmark index has rallied sharply since then, its PSU counterpart has nosedived to a fraction of the levels seen in 2010 (see table).
2003 2010 2021*
S&P BSE PSU 1,579.13 9,569.51 7,971.68
S&P BSE Sensex 3,383.85 17,473.45 52,474.76
* Closing levels as on June 11, 2021
 
At current levels, the S&P BSE PSU index is trading at 1.17x TTM price to book ratio, less than half of the Sensex’s price to book valuation of 3.3x. Though PSUs have been paying good dividends, currently their dividend yields stand at 3.18%, off from the highs of 6.0%. The dividend yield of Sensex stands much lower at 0.95%. Share of PSUs in the total market capitalization of all listed companies is around 9%, below the long-term average of 13.4%. We believe these valuations adequately capture the downside risks in the PSU stocks.

Presence of several triggers

Preference of growth-oriented stocks, fears of supply of government paper (divestments through ETFs) have been the key factors behind underperformance of PSUs over the past few years. We have seen a shift in government’s approach from ETF-based divestments (at discount to stocks’ valuations) towards strategic divestments (open offer at higher prices). This shift is providing confidence to investors.  

We believe, multiple triggers are in place and could lead to a rally in the PSU stocks from here on. Most of the businesses are in a monopolistic/leadership position in their respective sectors. Thus, they are well placed to capitalize on the economic recovery. Candidates for disinvestment such as BPCL, Shipping Corporation of India, IDBI Bank, BEML could witness significant upcycle once the process starts. Post disinvestment, most PSUs are likely to witness a healthy turnaround in their business and could also adopt enhanced governance practices. Historical evidence suggests that as government’s stake falls in a PSU company, its market capitalization improves. Investors should also note that PSUs have demonstrated a track record of paying dividends, consistently.

Our top picks

We like Coal India, SBI, Bank of Baroda, oil marketing companies (BPCL, HPCL and IOC), NALCO, SAIL and IRCON International.

Any delay in divestment process, slower-than-expected economic recovery and high competitive intensity from private players are key downside risks.

By Sheetal Agarwal

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