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Business News/ Markets / Stock Markets/  PSU stocks rally: Market overly focused on near-term profitability, ignoring large downside risks, says Kotak Equities
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PSU stocks rally: Market overly focused on near-term profitability, ignoring large downside risks, says Kotak Equities

PSU stocks have seen a sharp rally over the past 12 months, generating 19 - 443% returns over this period. Capital goods, electric utilities, financials and oil, gas & consumable fuels have been the major leaders in the PSU rally.

PSUs in the capital goods sector have seen a sharp rerating in their multiples over the past year, driven by increase in order books and elevated profitability and returns. (Image: iStockphoto)Premium
PSUs in the capital goods sector have seen a sharp rerating in their multiples over the past year, driven by increase in order books and elevated profitability and returns. (Image: iStockphoto)

The stock market is very much focused on the near-term profitability of public sector companies and is ignoring certain large downside risks, as per Kotak Institutional Equities. The brokerage firm finds it hard to accept the market’s new narrative of PSUs that may have contributed to the sharp rally in state-run companies in recent months. 

“In our view, the market is overly focused on near-term ordering and profitability, while ignoring the large downside risks to medium-term profitability, business model challenges and disruption risks," Kotak Institutional Equities said in a note.

PSU stocks have seen a sharp rally over the past 12 months, generating 19 - 443% returns over this period. Capital goods, electric utilities, financials and oil, gas & consumable fuels have been the major leaders in the PSU rally. 

“We find certain assumptions, surrounding the medium-to-long-term growth and profitability of these sectors, to be highly optimistic. We doubt much has changed in most sectors," said the brokerage report.

Also Read: PSU banks surge on PM's pat

PSUs in the capital goods sector have seen a sharp rerating in their multiples over the past year, driven by increase in order books and elevated profitability and returns.

However, analysts at Kotak Equities believe that the market is underestimating the downside risks in assuming large order inflows for an extended period of time, especially in sectors such as thermal electricity generation.

“In our view, the government’s three-in-one role of buyer, owner and policy-maker/regulator creates uncertainty regarding the companies’ future earnings and returns," the analysts said.

Electric utilities PSUs have also seen a sharp rerating over the past year. Kotak highlighted that NTPC’s current valuation is meaningfully higher than the logical 1.25-1.50X P/B. 

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Meanwhile, it also believes the Street to be overestimating the growth opportunity in PowerGrid Corporation of India versus its own growth targets and underestimating the risks to the company’s RoE profile from competitive tariff-based bidding projects.

On state-run oil marketing companies (OMCs), Kotak is of the view that they are at a risk of high volatility in marketing margins or long-term disruption.

OMCs have seen a sharp rerating over the past year on assumptions of high profitability. 

“We are puzzled by the market’s confidence in the same, given large volatility in marketing margins in the recent past and high sensitivity of EPS to the same. Our profitability assumptions are much higher than historic levels, with limited visibility on the government’s pricing policy," it said.

Lastly, the low FCF-to-PAT ratios of the OMCs make P/E-based valuations irrelevant, the report added.

Also Read: The one-way ride on PSU stocks is beginning to look scary

Portfolio changes

Kotak Institutional Equities has added Pidilite Industries to the portfolio, with a weight of 150 basis points (bps), while exiting PowerGrid Corporation (190 bps). It has re-distributed the remaining 40 bps to SBI Life Insurance. 

PowerGrid Corporation has delivered strong returns of 69% over the past year and is currently trading at 2.4X FY2026E BV, which is at a significant premium to its fair multiple of around 1.5X BV. 

“We have historically seen PowerGrid Corporation as the best play on the electrification of the Indian economy, but current valuations more than adequately capture the growth opportunities for the next few years," it said.

It finds comfort in Pidilite’s earnings visibility, given the strong residential real estate up-cycle, which it expects to sustain for the next few years, strong market position with possibly weakening competition, comfortable profitability assumptions and low risk of disruption.

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Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.

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Published: 08 Feb 2024, 09:42 AM IST
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