The good are never free - The Public sector bank dilemma

The corporate decisions

Every firm out there has to make a few critical decisions that determine how successful they'll be. The investing decision (which projects they'll back and with how much money), the financing decision (how they will finance their growth - own capital, debt, equity), and the dividend decision (how they will share the surplus cash with the owners of the company).

In an ideal world, the majority stakeholders and the minority stakeholder would be aligned on these. Unfortunately for us, we do not live in a Utopia. And nowhere is the disconnect felt more strongly than in public sector companies. In today's post we look at a few critical areas where the majority and minority shareholder interests clash in case of public sector enterprises, and how they pay the price via their valuations.

The conflicts

Before we begin to dig into the conflicts, it is important to remember that a few of the conflicts may be the right thing to do for the government and even the nation as a whole, but might still be unfair to the minority investor. Consider for example the most benign form of conflict - loss making rural operations.

If you are a bank setting shop in the outskirts of a village with low population probably isn't going to do a lot of good to your financials. If you were a private sector bank working on an investment decision, you would probably exclude that region in your expansion plans. But for the government bringing financial inclusion to the masses is key - and hence the top PSBs may have to expand where the investing decision from a purely monetary point of view would have recommended otherwise.

This ofcourse is the better of the conflicts that arise. There could also be political pressure to extend loans to parties you otherwise wouldn't have lent to, leading to significantly dented asset quality for the banks - a key driver of the depressed valuations for these banks. Which brings us to the last overhang on these stocks.

The good are never free.

Let us assume that as an investor you make peace with these two factors. Pricing in a few basis points of profitability hit from unnecessary expansion, and some amount of NPA hit due to some imprudent lending. You still have to live with one very important overhang.

Acquisitions. You see the government if you're a good public sector bank with a relatively high quality book, the government will reward you - although you may not like the reward too much. What the government has made a habit of is merging multiple public sector banks, and the high quality bank is often merged with a weaker bank with a troubled book.

Vijaya Bank, a firm will relatively clean books bore the brunt of this gift last year, when the government decided to merge it with Dena Bank, a bank that had balooning NPAs. The markets were quick to react to the news, penalizing the other decent banks in the process, with Indian Bank most notably crashing fastest after the announcement.

In the more recent past, SBI has been trading at sub 200 levels for quite a while - valuations that make this behemoth bank look dirt cheap, especially given its ownership of key SBI subsidiaries, including a 100% ownership of SBI MF. While the COVID crisis will be catastrophic for the books of banks, it is unlikely to hit SBI to the extent reflected in its valuation drop. What the market seems to be pricing here, is that there will be a lot of public sector debris once the COVID crisis is done, and with SBI looking like the only PSB able to carry the weight, it will bear the brunt of the worst offenders in the PSB space.

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