Exit PSU holdings, says Kotak Institutional Equities questioning euphoria in many stocks

Brokerage firm Kotak Institutional Equities has advised investors to exit their public sector undertaking (PSU) holdings and not get carried away with the rally in these stocks. "We would recommend investors to use the rally in PSU stocks to exit most of their positions," the note said.

Kotak said that the rally in state-run names like IRFC, BHEL, SJVN and most others is driven by top-down bullish sentiment for PSUs in general, instead of any major bottom-up structural fundamental developments. This is evident from the fact that no PSU has delivered negative returns in the financial year 2024.

"We see several problems with the euphoric sentiment for PSU stocks," Kotak Institutional Equities wrote in its note, highlighting bullish short-term profitability and volume assumptions, incorrect valuation methodologies and unrealistic narratives as the major issues.

Kotak believes that the government's benign policies and regulations may benefit PSU stocks in the short-term, but prevent them from addressing the large disruption threats to their business models in the medium-term. "However, continued large reinvestment of cash flows by PSUs into their extant business may constrain their ability to invest in more future-proof businesses, which is key to their longer-term viability," the note said.

Kotak highlights that most PSU companies have outperformed their private peers and are trading at valuations that are well above their private counterparts on a one-year forward basis.

An example is within the metals sector, where stocks like Hindalco and Tata Steel have gained between 30% and 50%, while its PSU counterparts like SAIL and NALCO have gained anywhere between 60% and 100% in the financial year 2024.

The note also mentions that while most PSUs have delivered strong returns, most of them are names with very low free float. Stocks like IRFC and FACT have gained between 300% and 400% but have a very low float in the market.

The note also highlights that despite this rally, most foreign portfolio investors (FPIs) have stayed away from PSU stocks as they may not be anticipating any major shift in the governance or operations of these companies.

FPIs are significantly underweight in PSU-led sectors like capital goods, oil, gas and consumable fuels, and PSU banks, according to the brokerage.

As a result, it advises investors to use rallies to exit their positions in PSU stocks as most non-financial PSUs are trading at very expensive valuations compared to their private peers despite weak fundamentals, weak business models and a growing "risk of existential irrelevance."