Investment in securities market are subject to market risks. Read all the related documents carefully before investing

New Guide Available for Download
Small Cap Multibaggers
in the Making

mailtimers.com


**Important: We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
**By submitting your email address, you also sign up for Profit Hunter, a daily newsletter from Equitymaster
covering exciting investing ideas and opportunities in India.


AD

Are Indian PSUs the New AAAPs (Avoid at Any Price) in Town?

Jan 8, 2021

A colleague and I were discussing an auto stock the other day.

The stock had jumped 6% intra-day and was looking strong to go up another 20%-25% over the next few months based on my assessment of its fair value.

My colleague didn't agree though.

'No, Rahul, the stock is a dud if you ask me,' he replied when I bounced off the idea to him.

'It is a marginal player in the industry and has hardly recorded any growth over the past few years.'

According to him, the best way to play the theme was to invest in market leaders as the company will never be able to catch up with its bigger, nimbler counterparts.

He doesn't mind paying even a significant premium in terms of valuations to market leaders if push comes to shove.

Although he was right in his own way, I had a slightly different take on the issue.

He seemed to be of the view that one should always buy the best of the best and should never invest in the third-best or the fourth-best company in an industry.

--- Advertisement ---
Investment in securities market are subject to market risks. Read all the related documents carefully before investing

Don't invest in small caps...

A small group of Equitymaster readers are going to hear from our Head of Small Cap Research tomorrow at 5 PM.

Book your spot at this meeting and get this complimentary guide delivered to your inbox.

Book your spot
Details of our SEBI Research Analyst registration are mentioned on our website - www.equitymaster.com
---------------------------------------------------

And this holds true at any valuation level. For him, the company was an 'Avoid at Any Price (AAAP)'.

This is not how I approached things though.

For me, unless the company has extremely broken fundamentals, is frequently loss-making and has a highly leveraged balance sheet, it is certainly worth something. And when it becomes available at a good enough discount from this fair value, it should be looked at as a potential investment candidate.

The stock under discussion was certainly one such company.

Although its profit growth has stagnated, it has had remarkably consistent profits before the pandemic struck, has almost zero debt on its balance sheet and does have sound growth plans for the future.

Thus, while it may not be valued as highly as the leaders in the sector, it does deserve a valuation of some kind. And I am of the view that at the current price, it is trading below even this conservative estimate of its true value.

It remains to be seen who gets this one right, whether me or my colleague.

Nonetheless, this is a perennial debate in investing. And right now, it is being played out quite strongly in the field of PSUs.

There's a whole bunch of investors who do not want to come anywhere close to any PSU stock mainly because the interest of the promoter i.e. the Government of India is most of the times at loggerheads with that of the minority shareholder.

--- Advertisement ---
Investment in securities market are subject to market risks. Read all the related documents carefully before investing

How to Potentially Build Wealth Safely... Without Taking on Excessive Risk

Access Our Premium 'Low Risk, High Return Potential' Stock Research at 60% Off

Full Details Here
Details of our SEBI Research Analyst registration are mentioned on our website - www.equitymaster.com
---------------------------------------------------

The whole IRCTC saga has only added more teeth to their argument.

However, there are others who believe that these companies may not be as growth centric as their private counterparts, but they aren't totally broken either. A lot of the large PSUs have a strong track of earning handsome profits, keeping their balance sheets lean and paying out strong dividends.

Thus, when they fall to prices that incorporate a sufficient margin of safety, they should certainly be considered for investment.

As mentioned earlier, I belong to this second category of investors and therefore, I went about figuring out the valuation levels at which these stocks turn into a low risk, high return bet and the level beyond which they turn into high risk investments.

I took five major companies viz. ONGC, NTPC, Power Grid, Coal India and Bharat Electronics and tried to get a sense of their financial and valuation history.

Here are the broad thumb rules I could come up with which I think would be applicable to not just these five companies but also to the broader PSU universe.

For PSU stocks with strong balance sheets but with low growth or almost stable profits, one is better off paying no more than a single digit price to earnings multiple say in the region of 6x-9x.

Stocks like ONGC, NTPC and Coal India would fall in this category in my view.

Value Stocks: Stocks with Limited Downside but Good Upside Potential

Although they have paid handsome dividends which is the case with almost all the good PSUs, their profits have remained stagnant for many years now.

Therefore, unless there's a clear indication there's sustainable profit growth coming, we can assume status quo in terms of profits.

Worth pointing out that ONGC is up 130% over the last one year while NTPC has logged in 60% gains during the same period. Coal India too is up 45%.

A big part of the reason these stocks have given good returns over the last one year is how attractive the valuations had turned.

All the three stocks were trading at mid to high single digit PE multiples based on their normalised earnings and thus, had very attractive risk-reward ratios.

Please note that since these stocks are PSUs and since they have hardly grown their profits, one should insist on an earnings yield (inverse of the PE ratio) that's atleast twice the interest on fixed deposits. A PE ratio of 6x-9x does satisfy this condition.

The next PE band i.e. 9x-15x should be reserved for growth PSUs like Power Grid and Bharat Electronics.

These PSUs have done a great job growing both their toplines as well as bottomlines over the years and therefore, deserve a premium to the non-growth ones like ONGC and Coal India.

Thus, at a PE between 9x-15x, there's a strong chance one would have made good money on these stocks over a 2-3 year period. The PE band of 9x-15x also satisfies the condition of the earnings yield (inverse of PE ratio) be at least as much as the interest on fixed deposits.

My approach, being conservative in nature, leaves out quite a few PSUs that are trading at much higher PE multiples because of strong growth visibility. And to be honest, I don't mind paying another 30%-40% premium over the maximum PE of 15x provided the growth visibility over the next few years is quite high and the company has demonstrated strong growth in the past.

However, to pay an extremely exorbitant PE of well over 100x like in the case of IRCTC, is taking it too far in my view.

Forget PSUs, there aren't many private companies that have ended up giving good returns over a 2-3 year period when bought at PE of well above 100x.

Just as I am against the AAAP theory in PSUs, I am also against the BAAP approach, be is PSUs or a private sector player.

I have seen countless cases where one has had a bad experience even after investing in the best companies and one has had a good experience even after investing in the worst companies.

This goes to show that it is not asset quality alone that determines investment risk.

The price of the asset also matters. Besides, the big PSUs are certainly not the worst companies. And therefore, they should certainly be looked into below a carefully determined price point.

And these price points are what I have tried to arrive at in this piece.

Do you think I am correct? Do share your views.

Warm regards,

Rahul Shah
Rahul Shah
Editor and Research Analyst, Profit Hunter

Recent Articles

A Stock Watchlist Amid the Correction in Smallcaps March 19, 2024
Are smallcaps in bubble territory? Find out...
Market Crash? My Top Strategy for Investors in a Downturn March 18, 2024
How should investors approach the current market?
How Indian Companies Are Competing With Giants Like Google March 15, 2024
There are strong Indian companies in India's technology revolution.
Stocks to Profit from India's Semiconductor Boom March 14, 2024
These under the radar stocks are likely to benefit from India's semiconductor boom.

Equitymaster requests your view! Post a comment on "Are Indian PSUs the New AAAPs (Avoid at Any Price) in Town?". Click here!

1 Responses to "Are Indian PSUs the New AAAPs (Avoid at Any Price) in Town?"

VIJAY ARULDAS

Jan 8, 2021

The latest Hidden Treasure report is not available online

Like 
  
Equitymaster requests your view! Post a comment on "Are Indian PSUs the New AAAPs (Avoid at Any Price) in Town?". Click here!