Shunning Away From Indian PSU Stocks? Think Again As Some Of Them Can Prove To Be Great Investment Too

Public Sector Units (PSUs) have been among the worst performers in the Indian stock markets for several years. The government has often squeezed out money from PSUs in a short-sighted manner to overcome the fiscal deficit. Hence, the markets have grown wary of PSUs.

However, no matter how bad a business is, it can be a great investment at the right valuations. Given that dirt cheap valuations and PSUs are synonymous in today’s market, PSUs might prove to be great investments too.

Despite their reputation as wealth destroyers, some PSUs offer a chance to create wealth as well.

Here are a few factors that show the wealth potential of PSUs:

The Commodity Factor:

Apart from their government ownership, PSUs probably command a lower valuation because of the nature of their business.

Several PSUs operate in the asset-heavy metal and energy sectors, which are highly cyclical. Markets give a premium to companies that have a relatively stable income. The cyclical nature of the commodity business implies that earnings are not stable, leading to a discount in the valuation.

Recently, commodity prices have started increasing again, which could lead to a re-rating of PSU stocks. Some stocks like Steel Authority of India Ltd. have already tripled in value.

Capabilities & Advantages:

Most PSUs were established during the socialistic era when everything was micromanaged by the government. These PSUs had access to all advantages and privileges that the government had to offer.

The huge infrastructure PSUs have put in place (and continue to own) is irreplaceable and the industries’ in which most PSUs operate have a very low probability of disruption.

Companies in the transmission or pipeline business (Power Grid and GAIL) have an inherent advantage because no competitor would spend money on duplicating the networks without any assurance of finding consumers.

In the case of National Thermal Power Corporation (NTPC) and Power Grid, both companies have built assets which have revenues guaranteed by contracts, with a regulated 15.5% return on equity. Similarly, Manganese Ore India Limited and National Mineral Development Corporation were allotted mines at no cost. These firms are among the world’s lowest cost producers of manganese and iron ore.

Engineers India Ltd. has been running a successful consultancy business for the Oil and Gas sector. The company has huge cash reserves and no debt. It has consistently managed to generate strong cash flows and paid out dividends.

Though stepping into the engineering, procurement and construction business was a misstep, EIL realised its folly and has not been bidding for new orders in the business. The asset-light consultancy business has consistently generated high margins along with high returns on capital employed.

These factors indicate that the markets might have thrown the baby out with the bathwater.

Dividend Play:

Most PSUs have strong cash flows and pay out substantial dividends. The dividend yield of several PSUs is higher than the savings account interest rates offered by banks.

The CPSE Capital Restructuring Guidelines ensure dividends for investors. These guidelines mandate all Central public sector enterprises to pay a minimum annual dividend of 30 per cent of profit after tax, or five per cent of the net-worth, whichever is higher, subject to certain conditions.

That said, governments have sometimes forced PSUs to take up debt and make large dividend payments or acquire other PSUs. Such short-term oriented strategies can certainly have a negative impact on the PSUs’ financials.

Valuation Standpoint:

PSU stocks offer 6-7% dividend yield which is higher than the interest rates. Coal India Limited, which has a monopoly over coal mining in India trades at 11 per cent yield.

The growth rate also indicates the potential India has when it comes to infrastructure and power sectors. At the current valuations, PSUs don’t seem to have a large downside.

However, even if a few factors change in their favour, PSUs can see a significant re-rating. At this point, the risk-reward ratio seems to be favourable for investors.

In Conclusion:

Given the extremely low valuations across PSU basket, even a small positive catalyst can push the stocks upwards. Given the good growth rates and financial strength, most PSUs are worth significantly more than they are currently being priced at.

Surely, the government can cause problems; however, most of it already seems priced in. One can cherry pick a diversified basket of profitable PSUs with a high dividend yield. Certain PSUs, with their high dividend yield, can certainly serve as a parking space for extra cash.

One should not just ignore the entire PSU space. Proverbial diamonds are often found in coal mines.