Shares of Public Sector Undertakings (PSUs) have been underperforming the broader markets in the last few years.
As per a report by brokerage firm JM Financial, the BSE PSU index fell around 40 percent and 20 percent in the last 3 years and 5 years, respectively, against a rise of around 20 percent and 70 percent in the BSE 500 index, respectively.
Year-to-date (YTD), the BSE Public Sector Undertakings index is down 17 percent against a 16 percent rise in the BSE 500 index.
Frequent stake sales by the government and a hit on earnings of oil & gas PSUs due to COVID-19 are among the key reasons for the underperformance.
"Last three years, the BSE PSU Index has grossly underperformed due to consistent selling and reduction in stake by the government. Most PSU stocks are trading closer to the lower end of their historic valuations," said Rusmik Oza, Executive Vice President, Head of Fundamental Research at Kotak Securities.
As per brokerage firm JM Financial, the BSE PSU Index valuation is around 9 times P/E and 0.9 times P/B which is 25-30 percent lower than the last-5-year averages.
On the other hand, the valuation discount to the BSE 500 Index has further expanded to about 70 percent against 40-50 percent in FY16.
This is despite PSUs’ profitability and RoE/RoCE matrix not seeing a similar decline. Hence, as per JM Financial, the BSE PSU Index dividend yield continues to be significantly higher at nearly 3.8 percent while the BSE 500 Index dividend yield has declined to 1.2 percent.
The outlook
As economic indicators are showing signs of improvement, PSUs’ earnings are expected to improve with a gradual recovery in domestic and global economies.
Oza of Kotak Securities believes there is definitely deep value in most PSU stocks with healthy return ratios in a few of them but most of them have proved to be a value trap.
In the last 10 years, the BSE PSU index has made tops intermittently by trading at 12 times of forward PE a couple of times. Today, the index trades at 8 times on forward PE basis which is nearly one-third the valuations of Nifty50, Oza pointed out.
"The dividend yield of the BSE PSU index works to about 4 percent which provides a good margin of safety in today’s market. If investors return to the value theme in 2021 and hunt for stocks that can play catch-up then PSUs can fit in properly," said Oza.
There are many large-cap PSU stocks having good RoE, cheap valuations and high dividend yield.
JM Financial pointed out that media reports suggest a committee is working on a new annual target structure for the management of PSUs from FY22 and would link incentives to it.
This new target structure might be announced in the upcoming Budget on February 1 and is likely to focus on improving profitability and the RoE/RoCE matrix, market-cap, frequency and quantum of dividends, and the sale of the non-core assets, amongst others.
Besides, the government is trying to minimise frequent stake sales in PSUs via ETF/OFS as these create an overhang on the share price. This is being done to boost profitability and valuations ahead of plans for strategic disinvestment of a few PSUs so that the government can get more value from potential stake sales, JM Financial said.
Binod Modi, Head Strategy at Reliance Securities, also pointed out that the government now seems to be committed to avoid frequent stake sales and encourages senior management of PSUs to perform better by linking incentives with companies’ profitability. This overall bodes well for PSU stocks.
"We believe 2021 is likely to be good for PSU stocks, which enjoy better profitability and balance sheet strength," said Modi.
JM Financial expects a reversal of PSU de-ratings due to the government’s plan to avoid frequent stake sales and instead focus on stake sales via strategic disinvestment and align management incentives to boost profitability and valuations.
Gaurav Garg, Head of Research at CapitalVia Global Research believes 2021 might be a turn-around year for PSU stocks, but investors need to be very specific in selecting PSUs.
"Investors are getting lured by attractive valuations and high dividend yield, but growth is always a concern area, therefore most PSUs have not featured in the list of wealth creators in recent past," Garg said.
"Government has got very aggressive with respect to the privatisation of PSUs to unlock their valuations and meet the divestment goals to keep the fiscal deficit targets intact. Privatisation would also help the PSUs in becoming more competitive and efficient," said Garg.
Top picks
SBI (target price: Rs 340), NTPC (target price: Rs 125), Coal India (target price: Rs 180) and HPCL (target price: Rs 260) are Oza's top picks from the PSU space.
JM Financial has buy calls on GAIL (target price: Rs 125), HPCL (target price: Rs 235), BPCL (target price: Rs 415), ONGC (target price: Rs 120), Oil India (target price: Rs 130), Coal India (target price: Rs 200), NTPC (target price: Rs 143), Power Grid Corporation (target price: Rs 205) and SBI (target price: Rs 300).
Garg of CapitalVia Global Research said GAIL is a value buy and he believes this stock is worth buying at the current levels due to its attractive valuations as it is cheaper among its peers with a decent dividend yield as well. He expects GAIL to give returns of 18-20 percent in 2021.
BPCL is Garg's second pick as it is the first one on the list for disinvestment.
"BPCL is a value investment for the long-term and should be an investor's top priority. I expect at least 20-25 percent upside in the next calendar year," said Garg.
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