Last Updated on Sep 23, 2022 by Vyshakh

Globally, businesses are run by private enterprises, for example, Chaebols in South Korea and Keiretsu in Japan. A few companies are run by the State, especially in strategic areas like defence, banking, insurance, mining, and oil & gas. These units are called Public Sector Undertaking (PSUs). In India, Tata Steel is an example of a private sector enterprise, while SAIL is a PSU.

According to fundamental analysts, the core nature of a business DOES NOT change just because the owner of the business is different. Simply put, and all things being equal, the intrinsic value of a business (and thus its valuation per share) should be the same whether it is a private enterprise or a PSU, the sole difference being the style of management.

Origin of PSUs in India

Bharat’s Past glory-the envy of all!

Let me share some perspectives first. Forget going as far as the highly progressive Indus Valley Civilisation (2500 BC to 1900 BC); let us retrace back to the Mauryan Empire of 4th and 3rd Century BC and subsequently the GOLDEN Age under the Gupta Empire (mid to late 3rd Century BC to 543 BC). There is no doubt that India was a dominant global economic power then (Sone ki Chidiya), for which it had to bear the brunt of several invasions.

this led to 750 yrs of invasions and, thus, its decline!

The Gupta Empire collapsed in the 6th century, and India was again fragmented into numerous regional kingdoms. Successive foreign invasions started from the year 1200 onwards, and after 750 yrs of loot and plunder, left India bereft of its past material riches. In 1947, India gained Independence, but its partition, successive natural calamities, and a broken treasury did not help the noble intentions of the newly-born Republic.

Challenges post-independence

India thus had to embark on a path of rapid industrialisation, and the Five-Year Plan approach was the only option. But how could it achieve this with limited private sector capital? The Government of India had no option but to step in and promote or take over businesses (read Nationalisation). This laid the foundation for the entry of the government into the Indian business world.

PSUs: from 5 to 348 in just 40 yrs…

In 1951, there were just five PSUs in India, but in March 2019, this had increased to 348. PSUs operated across sectors, viz fertilisers, airlines, refineries, shipping etc. These PSUs represented a total investment of Rs. 16.41 lakh cr. as on 31st March 2019, and the total paid-up capital was Rs. 2.76 lakh cr. PSUs collectively earned a whopping Rs. 25.43 lakh cr. during FY 2018–19, and thus command a dominant position in corporate India.

… but PSUs market valuations lag private peers by a huge margin

Several PSUs (also called Maharatnas, Navaratnas or even Mini Ratnas) today command dominant positions in most core sectors and have fundamentals at par with some of their best-run private sector corporates. Yet, ironically, the total worth of listed PSUs (excluding banks) on the Bombay Stock Exchange (BSE) is less than 6.2% of the total market capitalisation. Not all PSUs have strong fundamentals, but many, which are currently loss-making, sit on extensive reserves of prime real estate/property carried in their books at close to zero historical costs. The market seems to be “least interested”.

Why is investor confidence lacking towards PSUs? How extreme is it? 

Given a choice, any investor would prefer to invest in an enterprise where there is “minimal” risk for each unit of potential reward. Despite attractive valuation, the most common push-back from investors towards PSUs is the risk of management continuity, interference by bureaucrats, relatively lower transparency and monopoly-led lethargy.

Right or wrong, this apprehension, unfortunately, determines market valuation. It is not unusual to see a few darling private sector stocks trade even at 100+ price-to-earnings (P/E) ratios while their PSU peers sometimes struggle in the sub-10 range. Likewise, on price-to-book value (P/BV) ratios.

The following graphs show the extreme valuation differentials using a few comparable examples.

  1. A scatter chart showing the stark difference in P/E multiples of PSUs and private companies.
  1. Long-term performance of Nifty50 (orange) vs Nifty PSE index (blue)

6t43Wh6m (1783×923)

Is the lack of confidence in PSU justified?

They say the market is ALWAYS right, but we beg to differ…

Using pure fundamentals, i.e., the business’s cash flow generating capacity etc., the table below provides a peek into some leading listed PSUs. Observe the 5-yr average ROEs, ROCEs, and key operating margins. Note the near absence of debt in the balance sheets.

Clearly, there is a significant mismatch between fundamentals and market valuation of PSUs. 

Source: Tijori Finance

The biggest challenge to rerating the PSU valuations in India is… “Overhang” 

Above apprehensions apart, we believe the key concern is the high level of state holding. Every year, the government announces a formal divestment target in the budget as it HAS TO RAISE MONEY by selling its shareholdings across PSUs. Like a dangling sword, this thus creates an “overhang” of stake sale, which any investor would hate to deal with on an ongoing basis.

 …but, maybe an out-of-the-box solution is right in front of us?

As an eminent market expert Jayakumar, MD, Prime Securities, recently suggested in his column, that the Government of India can solve the problem of “stock sale overhang” and thus put a stop to the value destruction of PSU stock prices in the market. According to him, if just the top 13 PSUs issued Bonus Debentures (BDs) by capitalising their reserves, the Government of India could raise up to Rs 1.45 tn. Jayakumar argues that subject strongly to certain financial conditions, this will:

  1. Take away the pressure of compulsive stake sales by the government
  2. Send a strong signal about the future cash flows to investors (as the debentures will at some point have to be repaid)
  3. BDs issued at a reasonable coupon rate (say 6%) will be readily accepted by retail investors directly or via Bharat Bond ETF wrap structures – maybe even by foreign investors and by Indian banks {which are currently sitting on excess liquidity with approximate Rs. 8 tn parked by them with the RBI at 3.4% coupon}
  4. Energise the secondary bond market trading as these BDs will be listed
  5. Most importantly, increase the profitability of issuing PSUs as they save on Dividend Distribution Tax (DDT) and get a tax deduction on the interest they pay to BD holders

 So, is there light at the end of a dark tunnel?

In what probably seems like one of the boldest decisions since the 1992 reforms, the Honorable Finance Minister has announced a clear agenda of “strategic sale” of select PSUs. The Honorable Prime Minister also recently reiterated the Cabinet’s firm resolve in this regard, stating clearly on the floor of the Parliament that THE GOVERNMENT HAS NO BUSINESS TO BE IN BUSINESS. Committed implementation is now awaited.

Conclusion: patience will pay!

As the world returns to post-pandemic business, the race for quality assets will commence!

One needs to weigh fundamentals vs sentiment (read liquidity) when investing. PSUs offer a great opportunity to any long-term foreign buyer looking to expand his footprint in what will be potentially, the world’s 3rd largest economy after US and China. Indian entrepreneurs are not far behind in the race to acquire good-quality assets. Tatas have demonstrated their mettle in turning around Jaguar Land Rover and even the state-owned VSNL. The Mittals did the same with East European Steel Cos in the 1990s, and Vedanta promoters successfully turned around Hindustan Zinc – the results are for all to see.

Eventually, as they say, “Beauty lies in the eye of the beholder” …

Look at many deals done globally. It is not uncommon to see private equity/angel investors put money into “ideas” even at the inception stage, hoping the business will succeed SOME DAY. There is NO/very limited track record. Business models are generally on paper to start with, with no real cash flows or dividends to rely on. But multibillion-dollar deals are done using valuation metrics, jokingly known as “Price to Fantasy” ratios.

Isn’t it logical for investors to BID aggressively, if via strategic sale, they get a chance to own, manage, and control dominant, stable PSUs that are for sale? And what if they have time-tested business models, generate high cash flow, pay dividends consistently, and are available at reasonable valuations?

Call me old school, but if you SHOW ME THE MONEY, I will INVEST my hard-earned capital. I need to see strong brand equity, dominant positioning, a light balance sheet (if possible), high return ratios and a consistent dividend track record rather than relying on “we hope the business will make money after 10 yrs” kind of talk… Profitable PSUs fit the bill very well for my long-term investing style.

After all, as the saying goes, The Slow but Steady Tortoise Always Wins over the Quick but Hasty Hare!

Disclaimer: Mr. Dick H. Mody, Founder CEO of Ethical Advisers is a SEBI RIA. None of the contents of this article should be considered as investment advice. Mr. Mody and Ethical Advisers shall accept no responsibility of profits or losses occurring out of investment decisions based on the contents of this article. Mr. Mody as well as past and present clients of Ethical Advisers may or may not have open positions in the securities discussed in this article. Please assume that we are biased and have vested interests in publishing the same.

Dick Mody
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