Despite the recent surge in public sector undertaking (PSU) stocks, Kotak Institutional Equities is cautioning investors about the market’s narrow focus on short-term gains and profitability, neglecting substantial downside risks to medium-term profitability, business model challenges, and potential disruptions, according to a note from the firm.
Over the past year, PSU stocks have experienced a robust rally, yielding returns ranging from 19% to 443%. Notable leaders in this rally include capital goods, electric utilities, financials, and oil, gas & consumable fuels.
Kotak Equities questions the optimistic assumptions surrounding the medium-to-long-term growth and profitability of these sectors, expressing skepticism that much has fundamentally changed in most of them.
Specifically, in the capital goods sector, PSUs have witnessed a significant rerating in multiples due to increased order books and elevated profitability and returns. However, Kotak Equities contends that the market is underestimating the downside risks associated with assuming large order inflows for an extended period, particularly in sectors like thermal electricity generation.
The analysts emphasize the uncertainty introduced by the government’s triple role as buyer, owner, and policy-maker/regulator, creating potential uncertainties for companies’ future earnings and returns.
Electric utilities PSUs have also experienced a rerating, with Kotak highlighting that NTPC’s current valuation surpasses logical levels. The report suggests that the market may be overly optimistic about PowerGrid Corporation of India’s growth opportunities, potentially underestimating risks to the company’s Return on Equity (RoE) profile.
Concerning state-run oil marketing companies (OMCs), Kotak warns of high volatility in marketing margins or potential long-term disruption. Despite the recent rerating based on assumptions of high profitability, the report questions the market’s confidence, pointing to historical volatility in marketing margins and limited visibility on the government’s pricing policy.
In response to these concerns, Kotak Institutional Equities has made portfolio adjustments, adding Pidilite Industries to the portfolio while exiting PowerGrid Corporation. The firm emphasizes Pidilite’s earnings visibility, strong market position, and low risk of disruption, contrasting it with the perceived overvaluation of PowerGrid Corporation.
The report concludes by highlighting the low Free Cash Flow (FCF) to Profit After Tax (PAT) ratios of OMCs, making Price-to-Earnings (P/E)-based valuations potentially irrelevant.
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