Investors need to exercise prudence after PSU funds' robust surge

Only high-risk investors should take limited exposure to these funds, provided they have a long horizon

Mutual funds belonging to the public sector unit (PSU) theme have fetched an average return of 42 per cent over the last year. The bulk of this rally (28.9 per cent) took place over the last six months. While the theme may continue to perform, investors need to exercise caution after such a steep run-up.          

Earnings upsurge, low valuations

Multiple factors are driving the rally in PSU stocks. According to Ashutosh Bhargava, fund manager and head-equity research, Nippon India Mutual Fund, “Many of these stocks are in cyclical sectors like infrastructure, power, and banking, which are witnessing a meaningful recovery.”

Earnings have improved. The net profit of PSU financials had plunged at a compound annual growth rate (CAGR) of 14 per cent between financial year 2015 and 2020 due to banks’ poor asset quality. “As banks’ balance sheets were cleaned up and their asset quality improved, profits expanded at a CAGR of 85 per cent between FY20 and FY23,” says Dhimant Kothari, fund manager, Invesco Mutual Fund.

Non-financial PSUs, too, witnessed a turnaround. “After declining at a CAGR of 1 per cent between FY15 and FY20, their net profit rose by a CAGR of 21 per cent between FY20 and FY23,” says Kothari.   

Chintan Haria, head-investment strategy, ICICI Prudential Asset Management Company (AMC) says a decade of underperformance between 2011 and 2021 had made valuations very attractive.

The post-Covid economic recovery was positive for PSUs. “Higher commodity prices helped the commodity-oriented PSUs, while a strong order book helped defence and railway PSUs,” says Kothari.  

According to Haria, the boom in government capex, defence indigenisation, China+1 initiative, and the well-performing energy sector are factors that have brought PSU stocks back into the spotlight.

Unique strengths

Many PSUs enjoy access to resources, have first-mover advantage, or enjoy monopolistic market positioning. Fund managers say government intervention has reduced. Says Kothari: “The government has adopted a two-pronged approach towards PSUs: monetise or modernise. In either case, shareholders stand to benefit through value unlocking or efficiency gains over time.”

Diverse theme, disparate triggers

The PSU theme is diverse. Its varied parts respond to different triggers. Says Ankur Kapur, investment advisor, Plutus Capital, “Commodity sector PSUs do well only when there is an upswing in the commodity cycle.” Commodity cycles, driven by global dynamics, are hard to time correctly.    

The quality of management’s capital allocation decisions is a key criterion when evaluating a stock. Says Kapur, “Partnering with the government as a capital allocator is not the most efficient way to grow your money. While not all PSU managements are poor, the private sector is broadly viewed as being more efficient at managing capital.”

A sharp slowdown in the domestic economy would affect PSU stocks, which mostly belong to cyclical sectors. Political uncertainty and change in policy due to a change in government can also affect them adversely.

Index valuation remains subdued  

The rally in PSU stocks was driven by earnings growth, with no material change in valuations. “The current trailing 12-month price-to-earnings (P/E) ratio of the PSU index is 9.5x versus 22.2x of the Sensex. This translates to a discount of Rs 58 per cent to the Sensex, higher than the 10-year average of 50 per cent,” says Kothari. He adds that the PSU index is currently trailing its own long-term average valuation of 10.9x. He believes PSU stocks’ earnings could continue to grow at a healthy pace and valuation re-rating could follow.

Proceed with caution

Other experts advocate caution after the run-up. Says Haria: “Now it is a relative play owing to the belief that India’s capex will continue to boom over the medium term. Valuations are no longer cheap. Investors should do better due diligence and choose funds accordingly.”

Thematic funds, including PSU funds, carry higher risk than diversified equity funds. Only an investor with a high risk appetite should go for them. These funds should be kept in the satellite portfolio. Exposure should not exceed 5 per cent of the equity portfolio. Entry should be staggered and the investor must have a horizon of at least seven years.