Can reforms turn PSU stocks into multibaggers?

Jun 9, 2014

In this issue:
» PSU managements cry out for autonomy
» PSU banks may get to raise their own funds
» SEBI asks government to park surplus PSU cash in MFs
» Can the ECB's measures revive Europe?
» And more!

It certainly does appear that the new government has settled into its job quite fast. A few reform announcements have already been made. The intent that is being communicated is even more encouraging. This government is certainly different from the last one in this crucial aspect. It wants to be seen as a force for positive change. This has definitely enthused industry and markets alike. Analysts are busy figuring out which sectors will benefit and in what way. There is one sector that should benefit the most from the new government's reforms: the PSU sector.

Public sector undertakings (PSUs) are companies from various sectors from airlines to steel which have a majority government ownership. Yet they are all plagued by similar problems. The most important one is a lack of autonomy of the management. It is common knowledge that the government interferes with the functioning of PSUs. The boards of directors are not able to assert themselves and the government usually has its way. Profitable PSUs are treated liked cash cows and milked by way of dividends and the unprofitable ones are not allowed the freedom to clean up their act. This results in a complete lack of accountability which negatively affects their financial performance. However, things may be changing for the better. Narendra Modi has always maintained that PSUs ought to be reformed by providing their managements more autonomy. This would certainly be a step in the right direction but how to go about it?

Singapore could offer India a solution in the form of a proven success story. We are referring to Temasek, the holding company of the Singapore government. This 40 year old company was set up to manage the government's holdings in its public sector firms. This allowed the finance ministry of Singapore to focus on policy making. Temasek went about its task by bringing in a corporate structure to these companies. The boards were made independent and accountable. Long term business plans were drawn up and professional managements were asked to implement the same. Did it work? It certainly did! Many of these firms are well known global names today. Singapore Airlines, DBS and SingTel are leaders in their respective industries. Temasek's investment portfolio has grown at a rate of 13% CAGR! Can such a 'holding company model' for PSUs work in India?

The Temasek model does provide important lessons for India. However, the wounds of Indian PSUs are self-inflicted. Thus we will need to find a home grown solution for the same. There are currently 229 PSUs under the centre. The government could thus start by deciding in which sectors it wants to remain and which it should exit. This would allow the government to focus its efforts. The PSU managements should be freed from political interference. Internal issues related to HR policies, audit and the use of technology should be left to the managements. The boards of these companies should be made independent and professional. Once these reforms are in place, India could then consider setting up a holding company for the most well managed PSUs. Without the burden of having to reform them, this holding company would be free to invest the surplus funds of the PSUs, in assets around the world.

We believe the challenges related to PSU firms are many but they are not insurmountable. There is huge untapped value in these firms. We hope the government will use its mandate as a great opportunity to unlock this hidden value from its PSU assets. If the government succeeds, then PSU share holders could multiply their wealth in such stocks.

Do you think that that new government will able to unlock value in PSU stocks? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
Sticking to the PSU theme, we know how all of India Inc seems to be basking in the glory of a strong re-rating. Do you know which sector is at the forefront of this change? If CLSA is to believed it is the PSU pack of course. As per the renowned brokerage, PSU firms as a category has seen 1% and 5% earnings upgrade over the last three months. Why this sudden volte face you may ask? Well, it is the Modi effect of course and also the fact that valuations were so beaten down at these PSU firms that they only seem to be playing catch up right now.

Besides, there are some heartening signs on the ground as well. Take for example banks, easily one of the most prominent groups among PSU companies. Here, investors are encouraged by slow down in corporate debt restructuring accretion. On the energy front, another big source of PSU companies, declining under-recoveries in areas like diesel is another positive. Thus, investor optimism is certainly not without reason. However, it would be naive for investors to bid the PSU sector companies too high, too early. A measured approach is the best way to go about it we reckon.

First earnings upgrade for PSU firms in months

Till a while back, it was not uncommon to find some of the key management positions in public sector enterprises vacant. These included key positions such as that of Chairman and Managing Directors as well. This is just one of the many issues that PSUs have been facing for a while now. Over governance, succession planning, better efficiency and transparency are other key aspects that need some fixing as well. As reported by the Mint a few days ago, there are 229 state-owned firms in India. However, more than 80% of the profits are contributed by the top 10. As aptly put by the Chairman of SAIL Limited, "The business of the government is not to do business. There is a lot of interference happening. There has to be separation of ownership and management."

All of these aspects together have made many investors stay away from PSU companies altogether in the past. But now, with strong hopes of all this about to change, it seems that this stance is changing. This we say because the BSE-PSU Index is up more than 50% in the past three months. When compared to the BSE-Sensex's gain of 14% in the same period, it does give an indication of the kind of expectations set in. While the new government has already started to implement some changes, let's hope investors do not get disappointed in this regard.

Talking about autonomies, the one sector which perhaps can benefit greatly from independence in decision making is banking. Especially the PSU banks which are saddled with bad loans. Unprecedented lending and poor credit checks have led to deteriorating asset quality. Further, inefficiency of management created problems in loan recovery as well.

Recapitalization seemed to be the only way out. However, it is a distinct possibility as the government itself is in a fiscal mess. Basically it does not have money for recapitalizing PSU banks. As such, the finance ministry has decided to allow PSU banks to raise capital on their own. And one of the measures, apart from hiving off non-core businesses, is to raise capital via offloading government stake. The money thus raised will be pumped into the banks and will not flow to the government. Thus, the exchequer will not be able to extract money out of the stake sale. But this will enable banks to raise capital as the money will be reinvested in their business. Thus, the purpose of recapitalization will be served as banks will have money to fund future loans. While this move will help banks, it is a temporary solution. We believe what PSUs need at this time is a greater autonomy. And this can happen only when some sort of professionalism creeps into their corporate culture. This will ensure that banks lend prudently and the need for recapitalization does not arise.

We all know how foreign fund inflows have a huge impact on the movement of stock markets in India. The years particularly after the 2008 global financial crisis have been quite volatile in terms of foreign inflows. The 'emerging market growth' theme led to many of the foreign investors flocking to India in FY10 and FY11. But once growth began to slow down, this money began to find its way out of the country. This made the task difficult for the RBI which had to battle not only inflation but also the menace of volatility in foreign flows.

Thus, to encourage more domestic participation, SEBI has suggested that PSUs be allowed to park their surplus cash in mutual funds. It has also suggested a uniform tax treatment for pension funds irrespective of the investment routes. In addition to this, SEBI is also considering allowing companies to launch their own pension funds and invest some part of it in the capital market. While pension funds from foreign countries invest in Indian markets, so far domestic pension funds were not allowed to invest in equities. This could be a step in the right direction and bring more depth to the Indian capital markets besides doing away with some of the volatility associated with foreign funds.

If our government wants some lessons on 'how not to run PSUs', it needs to take home some key lessons from the debt crisis in Eurozone. Well, the European Central Bank (ECB) has been forced to take some seemingly ridiculous decisions in monetary policy. And as we wrote in a recent edition, the decisions are meant to undo past mistakes than safeguard the future. For the Eurozone, falling inflation is a bigger worry than growth. For it is inflation alone that can keep the value of soaring public and private debt low. High debt combined with deflation can be a terminal problem for the Eurozone. Hence to ensure that the debt repayment burden does not soar, the ECB is trying every trick in the book to stoke inflation.

Now allowing companies to keep borrowing cheap is certainly not the best way to grow. However, the European central bank has hardly learnt that lesson from its counterparts in the US and Japan. No doubt, it has so far refrained from printing money. However, we believe, it is only a matter of time before ECB resorts to money printing. Indian companies will therefore have to beware of risks of over leverage. Companies that have borrowed cheap in overseas markets, particularly PSUs, must get rid of unnecessary debt. Only once they have healthy balance sheets will the companies be able to convert growth into profitability.

The Indian stock markets were trading on a firm footing. At the time of writing, the benchmark BSE-Sensex was up by 175 points (up 0.7 %). Barring oil and gas, all sectoral indices were trading in the green. Realty and metal stocks were the biggest gainers on the bourses today. Majority of the Asian stock markets were trading in the green led by Hong Kong and Japan. European markets have also opened the day on a strong note as well.

 Today's investing mantra
"There are no bonus points for complicated investments." - Warren Buffet

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3 Responses to "Can reforms turn PSU stocks into multibaggers?"


Jun 18, 2014



ranjit kumar das

Jun 14, 2014

i like to be a member of profit hunter

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Jun 9, 2014


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