Morgan Stanley bets PSU stocks to pay off big

Says if govt engineers change like in Gujarat, PSUs could be 'surprising winners' in the next 3-5 years

US brokerage Morgan Stanley is positive on public sector undertaking (PSU) stocks, as it expects government action and reforms to turn around India’s PSUs.

According to the brokerage, if the Narendra Modi-led government at the Centre manages to engineer reformist changes - like the Gujarat-based PSUs witnessed when Modi was the state’s chief minister - Navratna firms, including Coal India and Power Grid could emerge ‘surprising winners’ over the next three-to-five years.

“Most investors in India are anchored to quality private sector companies and rarely have they backed SOEs (state-owned enterprises) to produce alpha. But SOE stocks appear inexpensive and under-owned with strong balance sheets though opaque profitability. If the government engineers change, as the PM's performance with Gujarat SOEs points to, these stocks could be the surprising winners in the coming three to five years,” said Ridham Desai and Sheela Rathi, analysts at Morgan Stanley in a report titled Corporatization of SOEs: The Third Stage.

Morgan Stanley’s most-favoured stocks in the PSU space are Coal India, Power Grid, Bharat Petroleum, NTPC and Oil and Oil and Natural Gas Corporation.

In the report, Morgan Stanley has highlighted that the return on equity of Gujarat PSUs increased by 30 percentage points in 10 years under the Modi rule.

The brokerage said investors should “shed their long-held skepticism” about PSU stocks, as these companies are likely to benefit from government action and reforms along with the coming growth cycle.

According to an analysis done by the brokerage, PSU stocks have underperformed the market by 55 per cent in the past 10 years. Also, these stocks are relatively under-owned by foreign investors as their holdings have nearly halved since 2007.

Morgan Stanley says PSU stocks are at least 30 per cent undervalued and nearly $60 billion cash balance of PSUs could be the “flag bearer of the next capex cycle”.

Some of the downside risks highlighted by the brokerage include “elevated supply of SOE stocks due to divestments, privatisation of sectors in which SOEs operate causing their monopolistic position to be challenged and the lack of skin in the game for SOE managers implying uncertainty for minority shareholders.”

Modi, in the run-up to the 2014 election campaign, had said: “As a philosophy, I believe the government has no business doing business. I inherited a number of defunct PSUs when I took over as chief minister (of Gujarat in 2002). People spoke of only two options: shut or sell. I came up with a third option, which was professionalising the companies and making them productive.”