Election Punts: If we get a strong government in 6 months

Stock Opportunities
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I was reading a LiveMint article of Nov 25: Cafemutual Confluence 2013: MF Panel discussion between 4 celebrated Fund Managers - Prashant Jain - HDFC, S Naren - ICICI Prudential, Anup Maheshwari - DSP Blackrock and Anoop Bhaskar - UTI.

Among all the general talk about how the only way Indian investors understand asset classes is by looking at past returns I was struck by one line from Anoop Bhaskar and that sort of stayed with me and I have been mulling over since then to investigate that line of thinking. This is that line

“I would say if there is one punt for the next election, it would be to buy the PSU Basket becasue if we have a strong government, then all the PSU companies will get re-rated. Some of these PSUs are large in size and you are dealing with something which is more tangible”

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This did gave me food for thought - certainly there are solid candidates which are being valued abysmally today. And all it takes is a strong change of sentiment (strong government formation), a few well-sounding (well-meaning) pronouncements, hint of progressive policy-making and hint of kickstarting infrastructure investments…and there we go.

Thought, this may just be the time - to start looking at out-of-favour industries and out-of-favour solid stalwart kind of companies ( a la Peter Lynch) - not necessarily PSUs, by the way.

Will start my investigations, and report my findings here. Meanwhile welcome ideas from everyone.

Cheers

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Donald,

I think there are PSUs which are market leaders and private players have negligible market share - Oil&Gas (ONGC, OIL, HPCL, BPCL, IOC, GAIL, Petronet etc), Power (NTPC, Power Grid, BHEL) and minerals (Coal India, NMDC etc) .

These may be grossly undervalued as most of them don’t have comparable private sector companies for valuation benchmark.

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The idea is appealing. I think a basket approach with probably 5 stocks , one from each sector mentioned by nav_1996 above & psu bank, & infra ?

“Best in class” with the highest undervaluation and a little semblance of conviction, with allocation of May be 15-25% of pf.

Idea is, to come out of position , the day election result is announced, if there is hint of weak govt. else continue to ride the position and possible fruit in case of strong govt.

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Among candidates we also have (apart from O&G, Power & Minerals)-

  • PSU Banks-- most of which are selling below Book due to NPA worries. Even after assuming 20%-30% erosion in book, a handful will still be selling below book. An improved sentiment can give good returns.
  • Monopolies like IGL, Concor which have good ROEs but lacking on growth. Can better policies improve their growth?
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Quite a timely post.

As rightly said beaten down PSU banks can prove to be excellent turnaround stocks as they will be the biggest beneficiaries of overall economic and sentiment improvement.

Since the depth of the delinquent loans hole is unknown, one can conservatively (extreme level) assume that ALL restructured loans and ALL NPAs are provided for from the networth. The bank with the lowest Price to this adjusted book value can be good starting points for further study.

Second point is that since our markets are so highly dependent on FIIs, one can shortlist those banks for initial study which have seen an exodus of FIIs over the past few quarters, as they are the ones where FIIs are likely to flock back in good times.

For eg Dena Bank has seen FII share drop from 17.8% to 8.6% in last one year. However, if I deduct all the NPAs and restructured assets from the networth, it turns negative. So it can be excluded.

The big daddy SBI saw FII share drop from 10.7% to 8.9% over last 3 Qs. The networth is 1364 Bn, and Restr+NPA is 713Bn. Adjusted book value per share works out to 952. At CMP of 1822, P/ABV is 1.9.

Is this a viable way forward to determine investible candidates? How can it be refined? Views invited.

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So these FPOs from Power grid, Coal India, EIL,IOC, & HAL seems to be a no brainer???

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Good topic Donald!

My sense is that market started factoring part stable government wave and it will keep on adjusting depending on election results and opinion polls of lok sabha elections. I

If we get a stable government then My bet would be Capital goods andPSU banksas with economy turnaround this are first sectors to turn. However it may correct from current level before election.

I think we can also narrow down this exercise to BJP coming to center as there’s strong NaMo wave and research on industries that’ll benefit from his policy/thinking.

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I would bag to differ with most of boarders here that it will be a good idea to buy PSU in the anticipation of a decisive/strong government. As I have been closely associated with energy sector as consultant, I have first hand experience of dealing with some of the largest PSUs (IOC/HPCL/BPCL/IGL/BHEL). There are some basic tenets around which PSU function which are inherently unfavourable to the investor.

  1. Meeting needs of the public and ensuring public good is the primary consideration for PSU, while making profit takes backstage. Typical decision making process emphasizes more on ensuring public good than ensuring the highest profitability of the company.

  2. Functioning and decision making of PSU is always prone to the whims and fancies of political leaders (irrespective of how decisive they are!). This is one of the biggest negative as many a times capital allocation decisions are based considerations other than merits. This is the case with even with Govt. of Gujarat, which I consider as one of the most business friendly and decisive government. Take example of any cash rich state PSU (GSFC/GACL) and you will see long list of investment made by these companies into totally unrelated ventures just because other state PSU needed money and state govt. directed cash generating PSU to invest in them! So,in PSU you are never sure that the management will deploy capital effectively and rationally.

  3. Another attribute of PSU is lack of proactiveness. The whole incentive system is built in a manner where by maintaining status quo is the safest thing to do. The reason is that in case if change in status quo result in success, your upsides are limited (may be you will get promotion in 2 years instead of 3!) and intangible, but if you fail (even after all due diligence and good intentions, there is always chance of failure) some one can initiate a departmental inquiry or CAG audit (which has the benefit of perfect 20/20 hindsight!) will lambast the department/official for taking a decision! You will hardly be penalized for not taking decision but you can lose your claim on pension or transferred to god forsaken place for taking a wrong decision.

I can add few more reasons to my arguments. But the limited point is that most of the PSUs in India are not run like an efficient business enterprise and management of these PSUs (government) do not strive to deploy capital in the best interest of the shareholders. So,if one is looking at purely short term opportunistic play to take advantage of changing market sentiment, one can take this “punt”, but its hard to make a strong case for investing in PSU for long term perspective, at least, considering current dynamics.

Best Regards,

Dhwanil

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Ya Dhwanil and the political mileage they like to generate at cost of PSUs… Or one can look at the sectors where structural reforms are going on/if any and private sector will jump in… Like Telecom few years ago and Digitization play…

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Dhwanil

There is no point in your post that one can disagree with. One point which you could have also highlighted is that the GOI keeps periodically destroying price by trying to divest further. Given two businesses with a similar business model, similar financials and similar current market price, one would definitely choose the private sector company over the public sector company.

However, I guess in investments, the issue is also the price which you purchase at, and within price, there is a risk embedded too. Buy at too rich a price, and well, you pay the price. So within this, one needs to figure out whether the PSU’s, as individual companies, and as a group currently have (for all the reasons you outlined above) a price which has very little downside risk to them.

For all the disadvantages PSU’s have, there are also some advantages:

a) Many PSU’s operate in a fixed return environment. Once they pay off their debt, and depreciate their operating assets, they will continue to throw up cash flow from these assets. Examples, NTPC, Power Grid, SJVN

b) Many PSU’s are able to borrow at much cheaper rates, since they have quasi soveriegn status, and can also issue tax free bonds.

c) In case PSU’s get into payment troubles, then the government bails them out-consider the state discom rehab scheme, which has bailed out REC, PFC and so on. The GOI cannot do the same for private sector companies, both from a moral hazard standpoint, and from a “discretion” standpoint. Witness the problems in rescheduling premium payments in the roads sector, as well as the case of OMC’s vs private sector OMC’s.

d) Many regulators have retired PSU staff at the helm. This causes a natural bias in the regulators towards PSUs. Witness the composition of the CERC. Recently, the Director (Finance) of NTPC was made a member of the CERC. Is he really going to work against NTPC interests while giving shape to tariff proposals?

e) In many cases, the government allots natural resources to PSUs, which it wants to give on an auction basis to the private sector. As a result, a company like NMDC has the lowest cost of production of iron ore in the world. They have mines, which will keep producing for several decades. Similarly with Coal India. Recently, SJVN was alloted a coal block. Try to allot a private company a coal block, in today’s environment, even for the most deserving project!!!

f) Many PSU’s give very good dividend yields. In fact the dividend yields on many top notch PSU stock are in the range of 4-7%. Why buy a tax free bond at 8.5% when you can get a dividend yield of 6% and some appreciation every years to the tune of 5-6%?

g) Many PSU’s have rich cash reserves. Take NMDC. Or take Balmer Lawrie. Net of cash on book Balmer Lawrie is available for around 100 Rs./share. The company has an operating Cash profit of around 35 Rs/share.

So with all the disadvantages, there are also several plus points. The question is ultimately one of price. Would I buy an NTPC at 125? Most definitely. Would I buy it at 200? Probably not. Would I buy an NMDC at 135 (with a 15 Rs. dividend waiting in the wings)? Most likely. Would I buy it at the 300 it was at last year. Most certainly not.

I believe that the central government is coming out with an Exchange traded fund, which will own shares of the top 10 PSU’s. This may be one for someone making a general punt. Personally, I would go bottom up for each individual company, and discount a fair price by 50% for government ownership.

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@Donald

Do you mean BJP coming in power is good governance where as congress is bad?

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Nice to see diverse viewpoints coming across.

@Dhawnil - Agreed about PSUs and the arguments raised in general. And that is exactly why they are valued where they are now. And folks like Ayush can tell us many more horror stories about how allocation decisions are taken.

Yes, we must recognise PSUs are a different breed. But as Hitesh says we must learn to ride different stocks differently, at different points of time. (I never tire emphasising this for those new to markets or limited experience with markets). There is no one holy grail to investing! There comes a time when entry into PSUs also make great sense, not for just a casual punt but nice concentrated bets over a 2-3 year economic cycle too.Personally I have made huge money over 2-3 year periods in many PSUs. You should have seen how SBI or EIL or BHEL or ONGC played out between 2006-2010.

Different stages of the market may call for different strategies. Guys like Anoop Bhaskar (of the Sundaram BNP Paribas Mid Cap Select fame) are veterans in the market. It pays to be open, collect data points and study what has worked at which stages of the market, rather…

@Vinay Ambekar - Nice pointers for taking things forward. Let’s work on refining strategies for the same. I am no expert but I do have access to some banking experts. Last time round (late 2008 and early 2009) when banks were available at 0.5x Book (SBI and Yes) with great concerns on deteriorating Asset Qualities - we had got a gem of an insight that usually bank asset quality cannot deteriorate beyond 5-6 times (multiply NPAs 10x to be absolutely safe for Yes Bank) as they have so many ways of restructuring loans…and we had a 7-bagger in Yes Bankin 5 months.

Lemme sound them out on their reactions.

My preference (at this time) would be to leave Oil & Gas PSUs alone as the Subsidy regime queers the pitch further, but infrastructure, CG and Banks should be good to work further on??

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Hi Samir,

Heartening to see so many points in favour of PSU! :slight_smile: As you very rightly pointed out, in investment, price is the most important element in making/breaking your investment returns. As they say, “price is what you pay, value is what you get!” .So the moot question here is that just because for example, say NTPC price have reduced from 200 to 125, means that it is trading cheap? May be not. Let’s do a cursory analysis of NTPC @ 145

NTPC total market cap:1,21,000 crores

Total debt: 75,000 crores

Cash + investments: 24,000 crores

Enterprise value net of cash and investment: 1,72,000 crore

Net profit: 12,500 crore in FY 13 (though half yearly profit for FY 14, has reduced by 10%)

Average yearly profit growth in 5 years: 9% (That too because of quantum jump in earnings in FY 13)

Additional capital deployed in last 5 years (net of cash and investment): 66,000 crores (1,33,000 crore in FY 13 and 67,000 crore in FY 09)

Additional return generated in last 5 years: 4500 crores (12586 crores - 8092 crores)

Average return on incremental capital deployed: (4500/66000) = 7%

So the investor is paying 15 times the net profit as enterprise value for a company growing at 9% CAGR while the return generated on incremental capital deployed in last 7 years is paltry 7%. In addition to that, one is taking the risk of partnering with a management (Government) who does not have shareholder value creation as the top priority. To add to this, company operate in a regulated business where upside is limited. So, is investor buying a business where odds of making superior return are in his favour?

Typically, one should selectively invest in businesses only when odds of winning are in one’s favour. This will enhance the probability of generating superior returns.

With respect to points raised by you on advantages that PSU enjoy, I do agree on some of the points but many of them are double edged sword. E.G., let’s say coal India is the only company which has been given license to mine coal for last 50 years. This means CIL has enjoyed complete monopoly. This monopolistic market has led to CIL becoming one of the most inefficient coal mining companies when compared to its global peers. Imagine, what will happen, if in the interest of the country, a decisive government start auctioning coal mining blocks to private players and CIL after 5 years will have to compete with BHP? It will be an uphill task for CIL to compete with highly efficient and customer centric private players due sheer inefficiency bred by 50 years of unquestioned monopoly. So something that is considered as advantage today, may turn out to be an Achille’s hill!

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Hi Donald,

I appreciate your view point that we must be flexible and open rather than clinging to a particular approach. But in the same breath, I would like to add that if one is investing with long term horizon in mind with an objective of generating above average returns, the odds have to be in favour of investors to achieve this objective. In my opinion, for long term above average returns, quality of management is absolutely critical unless one is buying the business at extremely cheap valuation. Alternatively, there should be some triggers in place which can change the business environment significantly.

If I understand correctly, our hypothesis is that post election if the strong government comes to power, there will be such triggers in place which will change the business environment significantly. Even if we assume that there is strong and decisive government in place (Which itself is a big assumption) there are some distinct possibilites

)- Even if there is a strong and decisive government at the centre, there may not be any short term solution to long standing issues in some of these sectors (power, oil & gas etc) as many of these problems emanate from structural/regulatory factors and will require stakeholder consultation/regulatory approvals/legislative changes etc

-Alternatively,the government may take steps which actually removes the monopoly in sectors where there is inherent inefficiency built in by the monopolistic behaviour of PSUs thus exposing PSU to competitive environment. If this happen, the whole paradigm for comapnies like Coal India, PGCIL, EIL (to some extent) will change and companies will be exposed to unchartered territory and historical performance/record will hardly have any relevance

So given these number of "if"s involved in the equation,isn’t premature to make an investment decision just because the company is a PSU and there may be a change in government in the next election? Doesn’t it more resemble to trading than “bottoms up” approach? Won’t it be more prudent to wait till actual policy/approach of the new government is known and then make investment decision? Even though, you may sacrifice some upside, but won’t you minimize the loss of capital? Moreover, if we are expecting to buy into highly undervalued PSUs where structural change will make them very attractive, even after paying slightly higher price, investor will still be able to make good money.

So on the lighter side, I personally feel, that to ride different stock differently,things have to be different in the first place! Especially when we know that we are partnering with a management that does not have shareholder value creation as the top priority!

I would like to qualify here that my views are based more from longer term investing perspective and I have no clue about trading in the market/timing the market. Hence, it may be entirely possible that I am missing the larger point!

Best Regards

Dhwanil Desai

** But time. ** too.Personally Bankin

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Dhwanil

I think the point of investing in NTPC is not to go for phenomenal returns. I compared the situation of buying NTPC stock to buying a tax free bond from NTPC itself.

NTPC is a completely regulated entity. If you see, the Return on Net worth is a constant 17% over several years. It would be, because the returns are fixed by tariff order. The whole point of the exercise was that if you invested in NTPC at 125, then you would give a dividend yield of 5% or so, increasing steadily, and then an increase of Net Worth and Book value by 7% or so annually.

Who buys tax free bonds? Those individuals who wish to have a fixed return with minimal risk. Instead, buy NTPC stock instead (at 145 the same economics are not so attractive as they were at 125). The only reason why the company would not give you around 13% tax free annualised over 10-15 years is if it could not deploy the entire increase in net worth into regulated power stations every year. That is unlikely with NTPC, since it has visibility of projects all the way till 2030.

And there is the wild card that many of NTPC projects will be completely depreciated and will be debt free within 25 years of commissioning. Many projects of this sort will come up over the next 5-10 years. Of course, the CERC will have to take this fact into consideration. But certainly, profitability of NTPC will increase as a result.

However, the only reason to invest in NTPC at 125 was as an alternative fixed return instrument. Not for eking out incremental returns.

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Dhwanil - I have only one thing to add. Do not paint every PSU/every sector with same brush. Analyse the performance data and they will tell you otherwise.There are contrarian opportunities in this market, for sure. I have learnt not to invest for the very long term. Even my best bets, I invest in only with a horizon of 2-3 years first - and evaluate every year/or at any change in business dynamics - if I can hold for another 2-3 years.

If you do not like PSUs so be it, but try and play the contrarian - there are private opportunities too in Infrastructure, CG and Banks that have been laggards.

The idea of this thread is to spur us into investigating and coming back with specific opportunities - and opportunities that we should be happy to hold for 2-3 years.

That kind of horizon should be good enough for most investors. Lets give theories some respite. Let’s get on to practicals.

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Hi Samir,

I appreciate your view point and investment thesis and in the context that you have presented, it surely does make sense.

Hope you take the points/counter points/ discussion in the right spirit. No offences meant!

Best Regards,

Dhwanil Desai

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Sure, Donald. I appreciate your point of evaluating each company separately rather than applying stereotypes to the whole PSU basket.

I have been active on this forum for last couple of years and have learnt and gained immensely from the boarders and senior valuepickrs like you, hitesh and ayush. But lot more needs to be learnt as such! As you many a times put it, it is the “ART” part which only comes from experimenting and applying various styles and creating a feedback loop around various approaches. I have probably just started my journey on this road! This aspect will become increasingly important as I am planning to take up investing as profession and full time activity in near future. So, I need to be more agile, flexible and open to learning new approaches towards investing. It will be great to connect up with you/hitesh/ayush over phone/in person some time to gain more insight to your journey, your experiences and more importantly your guidance.

Best Regards

Dhwanil Desai

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Interesting topic and very very vibrant discussions.

The big question here is IF we get a stable govt… First of all I have my doubts about that fact… The Indian electorate has been in the habit of doing the unexpected atleast in the past two general elections… First was Congress winning its first term when everyone was sucked into the India Shining story. Second was Congress surprisingly managing to cross the 200 seat mark when nobody was expecting it to.

This time, looking at market run up, I think the expectation is for a stable govt atleast and that too BJP dominated. Again I feel we may be in for a surprise… There could be a real hot potch result and then ONLY GOD SAVE US.

Putting the theories about results of election on backburner, I think if one were to bet on Modi and his allies forming next Govt at centre, the group to bet would be the Adanis… Adani Enterprise, Adani Ports, even Adani Power could be interesting bets. Even a Torrent Power could be an interesting bet. Narendra Modi’s reforms in power sector in Gujarat are there for everyone to see. He has almost semi privatised the Gujarat electricity board and might do something of a similar nature at Centre PROVIDED HE IS ALLOWED TO DO WHAT HE WANTS TO DO------- coalition politics will restrict his moves.

But this time around as compared to last time’s pre election times, the biggest difference is that index levels are at the highest levels whereas in 2009 markets were just coming out of a sharp correction and there was no hope of any kind of stable govt coming to power.

IF there is a strong govt at centre this time there will be no surprise as I feel most of that is priced… Surprise will be if there is some kind of hung parliament.

personally I would prefer to sit on the fence and watch how things play out… Maybe even increase the cash levels a bit and see how things go… Bcos if things god forbid go wrong, there could be a lot to lose from these kind of index levels.

One Caveat: Please dont take the views expressed too seriously… I have been wrong time and again in guessing macro events and macro moves.:slight_smile: I think we need to do the best we always do… at valuepickr… Find great businesses in their infancy, buy them cheap and ride the journey.

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No offence taken, Dhwanil.

Indeed, I am a contrarians sort of guy, who tends to fall in love with my own picks. So I really welcome a contrary view. It keeps me sceptical, which is very necessary for my personality.