Not too long, offices of stock brokers used to get crowded by their clients even before the markets could open. Everyone vied for the hot tip of the day -a winning stock that one could buy in the day’s trade. The story outside the trading terminals was no different. Banks and brokerage houses, in an exuberant charm, were dumping all sorts of financial products, without giving due weightage to what suited the investors objective. Stock ideas, mutual funds - be it any equity oriented retail product and immaterial of the style, theme / sector (they followed) and market capitalisation bias, were treated as licenses to have a bash on Dalal Street. One school of thought was completely looked down with disdain by the new breed of barmy investors was "value investing". It was completely ignored and value investors were ridiculed for not seeking a pie in the India’s so called perpetual growth story. But with changing times, exuberance of barmy investors fizzled and the value investing regained prominence since margin of safety became a concern. In this article we would analyse the performance of value funds and evaluate whether they really make a good investment in the current economic environment.
Essence of Value investing
Value investing is based on the idea that the in the near term the equity markets have little to do with fundamentals, and are subject to irrational and excessive price fluctuations due to ingrained tendency of most people to "trade", rather than "invest". Thus the father of value investing, Mr Benjamin Graham, has said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine."
It is noteworthy that the value investing has refers to buying stocks whose market value is severely deviated from their fair intrinsic value. Unlike market value, which is readily quoted, intrinsic value is not available easily and has to be estimated by conducting thorough fundamental analysis. The intrinsic value is a true worth of the business calculated by forecasting the present value of all future cash flows of the company discounted at prevailing interest rates. While carrying out fundamental analysis; various ratios such as Price-Book value (P/B), Price-Earnings (P/E), Dividend Yield, Price to sales are used as screeners to determine whether it’s a value company. Also, value investing revolves around set of investment principle which are:
- Companies should have sound management - Yes, it important to buy stocks which have sound management teams, as they are the one’s running the business for you investors to enjoy an appealing return on your investments. A company’s top management enunciates the company’s vision and ideologies, which should be evaluated well by you before investing your hard earned savings with the company.
- Earning capacity of the companies - Companies should be capable of generating good earnings consistently, as the fortune of its investors’ is dependent on the same. Hence, it becomes imperative to pay attention to factors such as brand equity, Earnings per Share (EPS) growth rate, amongst others.
- High Returns - Companies should be consistent performing ones and those who are capable of generating appealing return of equity as well as return on capital.
- Simple business - The business of the company should be simple and you as investors should have thorough understanding of the business model. As a prudent investor you should never buy a business / stocks the business model is far complex and beyond your understanding.
- Prudent approach towards debt financing - Yes this vital, because the company which is depending excessively on debt financing (particularly long-term debt) may eventually face a situation of a "debt overhang", whereby the interest coverage ratio of the company may get squeezed due to negative impact on the profitability due to rising interest cost.
- Buy at the right price - If all the aforementioned factors are satisfied, you should go ahead and buy companies / stocks. But while undertaking the stock picking activity, valuations need to be assessed as the objective of value picking is to buy companies / stocks at a reasonable price thus providing you a margin of safety.
- Long-term investment approach - This is the most vital point which is often ignored by many. While investing in companies / stocks you need to have a long-term investment approach, otherwise all the aforementioned investment principle would be defied, thus opening doors to momentum playing / gambling rather than "value investing".
Value style funds too by definition pick-up stocks for their portfolio that are under-priced and are likely to pay good dividends. While undertaking its stock picking activity the fund manager may discover value buying opportunities in various market capitalisations - so, you may find a value fund having exposure to large caps, mid caps and / or small caps. Report Card
Moreover, the fund manager may construe value in the line of business and the business model of the company which enables it to earn luring returns for its investors.
How Value Funds Have Fared?
Thus far there are 24 mutual fund schemes following the value investing approach, and their performance has been quite appealing. The table below reveals that on an average, the return clocked by them have outperformed by a noticeable margin against those clocked by the broader indices, such as BSE 200 and S&P CNX Nifty. Moreover, against the multi cap, flexi cap and opportunities style funds too they have outperformed. Also, the volatility in the returns generated by the value funds (as measured by Standard Deviation) is lesser than that of the benchmark indices.
*Category average of value funds is a simple average of 24 schemes following the value style of investing
|Scheme Name ||1 Year ||2 Years ||3 Years ||5 Years ||Std. Dev. ||Sharpe Ratio |
|Category Average of Value Funds * ||-5.8% ||-1.2% ||12.3% ||7.0% ||5.4% ||0.1% |
|Category Average of Multi, Flexi and Opportunities Funds** ||-6.9% ||-2.5% ||8.7% ||3.9% ||5.2% ||0.0% |
|BSE-200 ||-8.1% ||-3.9% ||5.7% ||3.5% ||5.6% ||0.0% |
|S&P CNX Nifty ||-5.6% ||-1.9% ||6.0% ||4.1% ||5.7% ||0.0% |
**Category average of multi, flexi and opportunities funds is a simple average of 57 schemes
NAV Data is as on June 18, 2012, Standard Deviation and Sharpe ratio is calculated over a 3-Yr period. Risk-free rate is assumed to be 6.37%)
(Source: ACE MF, PersonalFN Research)
A study of performance across market cycles (presented in the table below) - which reveals how consistently the mutual fund schemes have performed across bull and bear phases of the equity, depicts that although during the exuberant bull phase prior to the sub-prime mortgage crisis value funds underperformed, as everyone were chasing growth stocks; during the ensuing bear and bull phases post sub-prime mortgage crisis, value funds have performed better on average when compared to multi-cap, flexi or opportunities style funds. During the bear phase they have arrested the downfall, while in the bull phase (post sub-prime mortgage crisis) they accelerated due to better stock picking and margin of safety available during the preceding bear phase. Performance across Market Cycles
Even now while the global economy and the Indian equity markets and feeling the shivers of the Euro zone debt crisis, value funds have arrested the downside well during the present corrective phase of the markets. It is noteworthy that during the last bull phase (i.e. from March 9, 2009 until November 5, 2011), value funds have able to generate alpha and in the present corrective phase closing following returns as clocked by the broader indices.
*Category average of value funds is a simple average of 24 schemes following the value style of investing
| ||BULL PHASE ||BEAR PHASE ||BULL PHASE ||CORRECTIVE PHASE |
| ||1-Aug-2005 |
|Category Average of Value Funds * ||43.8% ||-53.5% ||89.2% ||-12.5% |
|Category Average of Flexi, Multi and Opportunities Fund ** ||51.5% ||-56.7% ||81.2% ||-13.2% |
|BSE-200 ||51.6% ||-59.0% ||84.4% ||-15.0% |
|S&P CNX Nifty ||50.3% ||-53.5% ||71.7% ||-12.7% |
** Category average of multi, flexi and opportunities funds is a simple average of 57 schemes
NAV Data as on June 18, 2012
(Source: ACE MF; PersonalFN Research)
Game Changer for Value Funds
The primary game changer for value funds has been the external environment. Earlier, during the period 2003-08 emerging economies were considered to have decoupled from the matured western economies and BRIC nations (Brazil, Russia, India and China) collectively were perceived as the only bright spots left in the world. India, after growing at a stagnated rate for decades, targeted and achieved the above 8% GDP growth rate during 10th five year plan (2002-2007). Massive investment plans were chalked out to sustain such high growth. Private sector was given a bigger role in the growth and thus corporate India was busy expanding businesses rapidly and accelerating revenues. This environment was conducive for growth style investing wherein investor readily paid premium to buy stocks having above average growth potential. During such periods, value companies which often said to have matured businesses look dull and insipid to investors, who were amazed with fast growing companies. Lot of Indian companies attracted investors with their envious growth.
And the liquidity Factor...
Gushing liquidity in the west created insatiable demand for emerging market equities. Foreign money coming in the Indian stock market was all leveraged. Traders happen to borrow from the countries with lower interest rates (such as Japan) and then used to deploy it in India to make quick bucks. Growth was the flavour of the season so sectorial stories were easy to sell, for example, the infrastructure story. To sustain growth rate of above 8%, India needed massive additions in infrastructure. For an investor seeking growth, the search for growth starts from identifying sectors exhibiting promising growth potential. On the contrary, value investing mostly involves in depth analysis of company fundamentals rather than predicting future growth of the sector in which it operates. This is one of the primary reasons why value funds didn’t work in the bull market of 2003-08. There were too many growth stories on offer luring foreign investors who were (and are) the main driving force of Indian markets.
Change of Perception
With the end of a secular bull market in 2008 many equations in the investment world have changed. The bear phase of 2008, which has often been compared with the great depression of 1929, has changed the attitude and shook the confidence of investors across the globe. For the first time in many years, investors found it important to take pains to recognise the difference between the good growth and the bad & self-destructive growth. Till then there was a common notion that value companies do not exhibit growth but the bear market of 2008 and the subsequent recovery period proved this wrong.
Owing to lack of judgment about their own businesses and exaggerated growth expectations, many high growth companies had landed themselves in trouble. Excessive use of debt, excessive capacity additions, entering too many verticals of businesses are some most commonly found self- destructive activities. Many such high growth companies went excessively aggressive in the bull run only to see their businesses ruined in the bear and subsequent recovery phase. The community of barmy investors had paid too much price for so called rapid growth. It was a lesson learned very hard way by them and value investing came back in vogue. Investments in value funds yielded good returns as there was more demand for companies with stable growth available at lower valuations.
Road Ahead for Value Funds…
Today, the troubled Eurozone is finding difficult to keep the show running with all most all member nations are experiencing anaemic growth. Although US looks relatively strong, it is not strong enough to boost investors’ sentiment. Decoupling theory of BRICs has already exposed its flaws by cooling growth rates and rising inflation in these nations. In absence of growth, investors would continue to be cautious on valuations, which in other words, mean value funds would stay in limelight for longer.
As mentioned earlier, the intrinsic value of a business can only be estimated and requires acumen to judge it. Not all companies trading at lower PE multiple or at a discount to their books values and having higher dividend yields would make good investments. These commonly used ratios may give a rough idea about the value in the stock but mere use of ratios may prove to be disastrous. Low PE could also mean the threat to sustainability of the revenues and profits. Since the dividends are paid out of earned profits; they will automatically fade with falling profits. Filter of book value may not be applicable to a company in non-capital intensive industry. Therefore, value investing requires acumen of picking right stocks and hence should be left to professionals. By its very nature, a value fund often holds contra view on the market and the stocks. It may create enormous wealth for investors but one has to be patient till the stocks in the portfolio are re-rated and the value is unlocked. Investors would be better served investing only in a value fund offered by a fund house with strong fund management skills. Value is judgmental and goes beyond mere screening stocks on few ratios. Algorithms cannot make you Mr. Warren Buffet.
This article was written exclusively for Equitymaster, India's leading Independent research initiative. Trusted by over a million members all over the world, Equitymaster is known for its well-researched, unbiased and honest opinions on the Indian Stock Market.