»5 Minute Wrap Up by Equitymaster

On This Day - 10 OCTOBER 2018
My Letter to PSU Companies: Why We're Not Recommending Your Stocks

Sarvajeet Bodas, Research analyst, The 5 Minute Wrapup

This is a reply to an imaginary letter received from the management of Public Sector Undertaking (PSU) companies.

Here goes...

Dear PSU,

Thank you for your letter.

I appreciate your concerns. You are upset with me.

I don't blame you.

In this letter, I will try to express my side of the argument. Hear me out.

You said in your letter that despite starting Smart Money Secrets 16 months back, we have not recommended a single PSU stock.

'Why such hate?', you asked.

You further said, 'despite coming in the screener list, still, there is no consideration for PSU companies.'

'Look at PSU space, we trade at reasonable valuations, we pay a good dividend and, in some cases, we have good ROE, ROCE', you said proudly.

I hear you PSU.

I know you're in a lot of pain right now. The market hates you.

But we, at Smart Money Secrets just can't afford to recommend your stocks at this stage.

Let me give you some recent examples which are still fresh in our memories.

Last month, the government (i.e. the promoter) proposed the merger of Bank of Baroda, Dena Bank, and Vijaya Bank to create India's third-largest lender.

  StockSelect  

The rationale was two strong banks will absorb a weak bank to create a mega bank.

This is a good move from the government's point of view. But think about it from the minority shareholder's point of view. In this case, from the point of view of the minority shareholders of Bank of Baroda and Vijaya Bank.

From their perspective, this merger is nothing but a bailout of the weak bank i.e. Dena Bank. As you know, Dena Bank reported a loss of Rs 19.2 billion in FY18.

Now such a big merger will have its own challenges and difficulties. This includes process integration, bank rationalisation, work culture and HR etc.

Besides, there are concerns of the NPA burden and the decline in the capital adequacy ratio. We still don't know what's the government's plan for infusing further capital into the bank.

In short, there's a lot of uncertainty. And minority shareholders don't like such things.

That was about banking.

Let's look at another example. That of oil marketing companies (OMCs).

What just happened last week?

The government directed the OMCs to absorb a cut of Rs 1 per litre of petrol and diesel. It is expected that this will lead to around Rs 45 billion hit in net profits.

I don't know about you but to the aam investor Rs 45 billion in profits is a lot of money. We get dividends from that profit. And the government made it disappear overnight.

Normally, such sudden decisions are considered as unforeseen regulatory risk. But in your case, it was already known!

All this while, the government maintained that they will not interfere with fuel pricing regardless of crude oil prices.

But look at what happened!

Since this decision, the market cap of OMCs has declined by more than Rs 750 billion.

It is important to note that OMCs were indeed on our screening list.

As you mentioned in your letter, they generate ROE and ROCE upwards 25%. The dividend payout was decent.

But this kind of risk was looming large over these companies. Since the valuation wasn't dirt cheap, we decided to stay away.

Now I come to my last example: Steel Authority of India (SAIL).

In August, the promoter (i.e. the government) demanded a dividend payment.

But SAIL, didn't have enough cash. For the dividend payment, SAIL would have had to borrow from the market.

Not to mention, SAIL has Rs 32.2 billion of debt repayment due this year.

Normally, shareholders love dividends. But just because SAIL turned profitable in the last three quarters, it doesn't make any sense to demand such an unreasonable dividend payment.

Thankfully, SAIL declined the government's request for the dividend.

I hope you are getting my point, dear PSU.

These are not isolated cases. There are plenty of such examples of government intervention in your business activities.

Dear PSU, I urge you to think from the minority shareholder's perspective. Then you will understand our pain.

'What do you want then?', you'd ask.

Well, you see, at Smart Money Secrets, we love businesses that show excellent capital allocation skills. These are companies with strong business models, a long runway of growth, the minimum impact of any regulatory intervention, strong promoter track record and many other things.

These are some elements of our Smart Money Score, a proprietary tool that helps us weed out companies that score poorly on fundamental factors.

Now you might ask a follow-up question to this... 'Does that mean there is no chance of you recommending a PSU stock?

If the valuations are dirt cheap, factoring in every negative aspect, then we might take a look you. But I am not promising anything.

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Because you see, at the end of the day, my comfort level is not that great with you.

Now, you know my reasons.

Hope you understand why I'm not recommending you now.

I know, this letter might hurt you. But that's the bitter truth.

Take care and all the best for the future. May it be better than your past.

My best wishes,

Sarvajeet Bodas

Chart of the Day

Since we are talking about PSUs, I thought, it would be an interesting to compare how these stocks performed compared to the frontline index - BSE Sensex.

The BSE-PSU index, which includes many companies from the PSU space, considerably underperformed the BSE Sensex.

Underperformance of BSE PSU Index

For three out of five years, the BSE-PSU index considerably underperformed the BSE Sensex. From 2014 till date, the BSE-PSU index gave a meagre annualised return of 3%. Whereas, the BSE Sensex delivered 14%.

This underperformance can be attributed to sector specific events such as non-performing assets (NPAs) in the banking space and rising oil prices that impacted OMCs, among others.

In Smart Money Secrets, we are not yet comfortable with the PSU space. We prefer owner-operator driven companies run by excellent management.

This month's upcoming recommendation is one such example. It fares very well on our proprietary tool - Smart Money Score.

A long runway for growth, strong sectoral tailwinds, negative working capital, strong brand recall, undervaluation of two of its business segments, and corporate restructuring of one of its business units to unlock shareholder value are some the key triggers for this company.

Watch this space!

Regards,
Sarvajeet Bodas
Sarvajeet Bodas
Research Analyst, Smart Money Secrets

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