PSU stock froth persists: Q4 test for financial endurance

Market volatility prompts scrutiny of PSU stock sustainability in Jan-mar

Shares of public sector enterprises have corrected by up to 22 per cent month-to-date until March 19, 2024. Analysts attribute this steep fall to the valuation exuberance seen after a sharp run in these counters last year and suggest investors remain selective regarding the stocks in this space.

“The rally in public sector undertaking (PSU) stocks has been stretched and sharp, although it is somewhat justified by improvements seen in earnings, operations, balance sheets, and overall profitability. Traditionally, PSU stocks have traded significantly lower than their private peers due to unpredictability in state policy and lack of long-term vision,” said Narendra Solanki, head of fundamental research-investment services, Anand Rathi Share and Stock Brokers.

Among PSUS, railway stocks such as RITES (formerly Rail India Technical and Economic Service), Indian Railway Finance Corporation, and Indian Railway Catering and Tourism Corporation dipped by 21.3 per cent, 8.1 per cent, and over 2 per cent, respectively, in March, according to ACE Equity data.

Oil and gas companies, including Hindustan Petroleum Corporation, Indian Oil Corporation, and Oil and Natural Gas Corporation, have also shed 13.8 per cent, 8.5 per cent, and over 4 per cent, respectively.

Moreover, other PSUS like NBCC (India), UCO Bank, and NMDC (formerly National Mineral Development Corporation) lost between 14 per cent and 15 per cent each in stock prices in March.

Analysts also believe PSUS have typically found it difficult to sustain their financials over a long period, and presently the markets have corrected due to a significant level of profit booking taking place in the space.

“Largely, the PSU stocks rallied on the argument that these companies had the rewriting and successive liquidity potential in the market due to which a significant level of new money was infused in the stocks. However, the corporate workings have not met the investor expectations and justification of the rally in stock prices,” said Deven Choksey, managing director, Drchoksey Finserv.

According to a recent report by Kotak Institutional Equities (KIE), the rally in PSU stocks is largely driven by top-down bullish sentiment for PSUS, rather than any major bottom-up structural fundamental developments.

The report adds that problematic euphoric sentiment for PSU stocks is based on bullish short-term profitability and volume assumptions, incorrect valuation methodologies, and unrealistic narratives.

Investment strategy

So, what should you do with the PSU stocks? Is the current fall a good time to average, or should you sell them on a rise?

The view remains divided. Analysts suggest investors keep a stock-specific approach as there is still an element of froth in some counters.

Those at KIE, for instance, suggest investors who currently hold these counters on a bounce-back should exit. Most non-financial stocks in the electric utilities, metals and mining, and oil, gas and consumable fuels sectors, they said in a recent note, are trading at very expensive valuations despite weaker fundamentals, weak business models in the context of mediocre free cash flow-to-profit after tax ratios, low or negative terminal value, and growing risks of existential irrelevance.

“The government’s policies and regulations may benefit PSUS in the short term, but ironically prevent them from addressing the large disruption threats to their business models in the medium term,” wrote Sanjeev Prasad, Anindya Bhowmik, and Sunita Baldawa of KIE in a recent report.

Commodity-driven businesses, according to Choksey, should be avoided at the current levels.

Railways and the defence sectors have high potential, but a few challenges such as pricing pressure, rate contracts, and cost passover remain. He recommends buying REC (formerly Rural Electrification Corporation) and Hindustan Aeronautics on a dip.

On the other hand, Solanki’s top picks include State Bank of India and defence company Bharat Electronics from a longterm lens.

“The fourth-quarter earnings will be a good test for PSU companies on their financial performance as the last quarter is the heaviest in volumes and accounts for the majority of their revenues,” Solanki said.