PSU Rally: Kotak Institutional Equities says market ignoring three downside risks

The brokerage wrote in its note that Capital Goods PSUs may not enjoy high profitability in perpetuity, meaning forever. The sector has seen sharp re-rating in multiples over the last 12 months led by a strong increase in order books and elevated profitability and returns.

"We agree with the brighter prospects of the companies, but believe that the market is underestimating the downside risks in assuming large order inflows for an extended timeframe, and perpetually elevated margin / return profile," the Kotak note said.

"In our view, government's three-in-one role of buyer, owner and policy-maker creates uncertainties regarding the companies' future earnings and returns," the brokerage note further said.

Kotak cited the example of NTPC, whose current valuation of nearly 2 times price to book value is meaningfully higher than the logical 1.25 times to 1.5 times. It believes that the street is ignoring its likely lower return profile in the long term, given the eventual transition to solar electricity, which will also consume Operating Cash Flow of the extant coal-based plants.

The street is also overestimating the growth opportunity in Power Grid compared to its own growth targets and underestimating the risks to the company's Return on Equity (RoE) profile from competitive TBCB projects, according to Kotak Institutional Equities.

Another pocket that has witnessed a tearaway rally are Oil Marketing Companies (OMCs), with HPCL BPCL and Indian Oil, all trading at record high levels.

"We are puzzled by the market's confidence in the same, given the large volatility in marketing margins in the recent past and high sensitivity of Earnings per Share (EPS) to the same," the note said.

Kotak Institutional Equities has exited from its positions in Power Grid, which was at 190 basis points. It has added Pidilite instead to the model portfolio with a 150 basis points weightage and the remaining 40 basis points are allocated to SBI Life.