PSU stocks are best avoided at this point

Samir Arora recently made an interesting point. Speaking at a conference, the legendary money manager said, he did not necessarily have full conviction about the stocks he picked. But he did have strong convictions about the stocks he did not buy!

This paradoxical attitude makes sense if you think about it. Many stocks have good points and appear worth buying. But even blue-chips can throw up unpleasant surprises and an investor has to be prepared for expensive mistakes. But once an investor has found a reason (or reasons) to reject a stock, he can pretty much forget about it, unless that reason changes.

Going deeper into Arora's argument, we have to look at the reasons for rejecting a stock. Sometimes "reasons" are cyclical. In some periods specific sectors do well. Sometimes, big stocks outscore small ones, and vice-versa. Demand for a product or service can change. Key variables such as the price of inputs or financing costs can also change. In these cases, the rejection can be reviewed, given a favourable shift.

However, some reasons are permanent. Management issues can be permanent, particularly so in companies, which are family-promoted and run - as so many Indian firms are. Other permanent issues include mistreatment of minority shareholders and a habit of fudging accounts. Companies where these issues are visible deserve to be rejected and the rejection should be permanent, since management DNA does not change easily.

There are many family firms that are well-run and honest in the presentation of accounts. Many family firms also treat minority shareholders well. And, every family business is run by people, who have grown up running those businesses and understand the nuances.

There is one "group" of companies that deserve to be permanently rejected owing to poor management. That is the PSUs. This is not because PSUs lack talent in the ranks.

Many PSU employees are thoroughly professional and well-educated and trained. Many PSUs also have an enormous edge in that they were allowed to operate as monopolies for many years. They control massive market share in many sectors - mining for instance, or retail marketing of fuels are still government monopolies.

So are power grids and defence manufacturing. Many PSUs still get excessive concessions from the government, such as preferences in tenders for shipping, or guarantees of telecom spectrum, etc.

The basic problem lies with the promoter. Governments tend to be bad at running businesses. In effect, whatever the management structure may be, most PSUs are subjected to political interference and excessive political control. This means policy is made by persons, who have little idea about the business itself and could not care less about profits. A joint stock corporation should be run to maximise the returns to shareholders and to distribute those returns evenly per share. Politicians' priorities are completely mismatched.

To take a few examples, wellrun PSUs are often "raided" for "special dividends". PSUs are usually not allowed to downsize staff. They may be told to take over sick units - refer to the history of the Dabhol Power Company for a terrible example. PSUs are often asked to "invest" in cross-holdings in other PSUs, which is effectively money handed over to the government. The PSU banks have often been ordered to give loans without being allowed to do proper due diligence. Unlisted businesses such as Air India and the Railways are run even worse than the listed ones!

It is impossible to be a passive investor and avoid holding PSU exposure.

But any active investor should avoid PSUs simply since they are PSUs. The BSE's CPSE index, which tracks 42 PSUs, has moved from 1,539 in October 2014 (when the index was rebased) to 1,564 today. That is approximately 0.4 per cent Compound annual growth rate (CAGR) during a long sustained bull market.