Optimal time to book profits

High valuations, limited earnings upgrade prospects warrant caution

Public Sector Undertaking (PSU) funds have run up by 93.6 per cent on average over the past year. Experts say investors need to tread with caution after this humongous run-up.

Improved fundamentals

In the past three years, business cycles improved in many of the sectors where PSUS have a presence. “As market leaders or dominant entities in them, PSUS benefited directly from the improvements in the fundamentals of those sectors,” says Anand Sharma, fund manager, ICICI Prudential Asset Management Company (AMC).

Financials, too, have taken a turn for the better. “Return on equity (ROE) of PSUS had dipped from 14-15 per cent in 2013-14 to 4-6 per cent, primarily due to the drag from PSU banks. The overall ROE has improved to 12-13 per cent with profitability recovering. Most PSUS have also seen large upgrades in earnings per share,” says Mahesh Patil, chief investment officer, Aditya

Birla Sun Life AMC.

Accelerated capital expenditure by the government, according to him, has bolstered this theme.

Strong and stable dividend yields have also positively impacted sentiment.

In every rally, as valuations turn expensive, investor focus shifts to less expensive options.

“This pattern was observed in PSU stocks, where many stocks were undervalued. Consequently, stocks particularly in defence, power, and railways, performed well,” says Vidya Bala, co-founder, Primeinvestor.

Will the rally continue?

While near-term performance is difficult to predict after a huge runup, fund managers believe the PSU theme’s prospects remain sound over the medium to long term. Patil points to visibility in revenue and earnings of sectors such as railways, defence, banking, and power. He emphasises that valuations are still cheap in sectors such as banks and oil and gas, compared to past levels.

Sharma is optimistic about the power sector’s prospects.

“Cycles tend to last for a few years in the power sector since fresh capacity addition takes time. With power demand likely to be reasonably strong over the next few years, we may see some amount of peak power deficit in the near to medium term,” he says.

According to Ankur Kapur, investment advisor, Plutus Capital, “If project approvals and fresh orders keep coming in, infrastructure and defence could perform.”

Beware valuation and other risks

Political instability, resulting in policy changes, could create uncertainty for PSUS. Divergence from the intended capex deployment programme could also pose a risk.

Experts say valuations for select sectors seem stretched while the scope for earnings upgrades, already at record highs, appears limited.

Profit booking by investors could also limit these stocks’ prospects.

In many parts of the PSU space, the expected wealth creation has not materialised in the past. “Many poorly performing banks were merged with the ones that were doing well leading to a drag on the latter’s performance,” says Bala. She points out that project execution and payment cycles are common pain points within the PSU universe.

According to Kapur, many PSUS cannot be regarded as high-quality companies. “They are characterised by low return on invested capital (ROIC),” he says.

One motivation for investing in select PSU stocks is the prospect of high dividend payouts.

“After the recent price surge, however, dividend yields have also declined,” says Kapur.

According to him, government control over these companies means decisions can, at times, be influenced by considerations other than purely business-focused.

Bala does not see any fundamental factors that could drive this rally forward. “If at all the PSU theme performs, it will be due to the continuing momentum within the market,” she says.

In a diverse theme like PSU, where some sectors (financials, logistics, power, and railways) are domesticoriented and others (oil and gas and metals) are influenced by global factors as well, investors would be better off trying to take a narrower (sector or stock-specific) view.

Book profits

Kapur warns that entering PSU funds at the current elevated valuations could lead to moderate or negative returns. Bala suggests investors book profits in these funds while they can. As for new investors, she says, the optimal time to invest is when valuations are significantly depressed, a phase that is behind us.