The best time to go digging for undervalued stocks is in a beaten down market. Over the past couple of months, we saw the benchmark indices free-fall by over 10%. Valuations too, took a hit. The price-to-earnings (P/E) of the S&P BSE 200 eased from nearly 24 times to around 22 times now. For value-style fund managers, this was an opportune time; because buying stocks at discounted prices meant enhancing the return potential.

With value fund managers doing their job, should you seize this opportunity to invest in value funds?

Finding value

While a market correction provides an opportunity for fund managers to pick up good quality stocks at a discounted price, it needs to be supported by inflows from investors. Most funds remain fully invested; they depend on fresh cash inflows for additional purchases. This time they were not disappointed. In October-November 2016, while foreign investors sold Indian equities to the tune of Rs 23,000 crore, domestic mutual funds buoyed the market by picking up a similar amount. So, hopefully fund managers were able to pick up good stocks at a discount.

But there are different approaches to value investing. Just because a stock falls substantially in price, it doesn’t directly imply that a value fund manager would go ahead and buy just any stock. He needs to discover value by delving deeper into the fundamentals and the business model of the company. This enables the fund manager to estimate the intrinsic value and know the true potential of the stock.

There are different methods to gauge the value of a stock. But the commonly used valuation measure is ratios such as Price-to-Earnings ratio (P/E), Price-to-Book Value (P/BV) and dividend yield ratio. A fund manager may use these quantitative ratios or a combination of these, along with other parameters to screen value stocks.

Don’t undermine the risk of ‘cheap’ stocks

Stocks are often priced at their future earnings. Therefore, if a stock looks undervalued based on its past or future earnings, the fund manager needs to dig deeper. Estimates on future earnings may not always be accurate. The company’s profits may fail to live up to the fund manager's expectations. As value stocks are mostly found in the small- and mid-cap space, where there is less research coverage, there can be cases of accounting irregularities or questionable management deals that can negatively affect the business earnings and indirectly the price of a stock. So, don’t forget, value investing can go wrong too. As an investor, you should be willing to take on that risk, and price movement of smaller companies is often volatile than their large cap counterparts.

Value investing requires tremendous patience. A good stock may remain undervalued for years, without any positive price movement. However, when the broad market identifies the potential of these stocks, the returns can be overwhelming. Therefore, when investing in value funds, you should have a long-term investment horizon of at least 5-7 years.

Is now a good time to invest in value stocks?

First, let’s take a look at how value funds performed over different market cycles. There are 21 funds that fall in to the value fund category. We’ve compared the returns of these schemes to other equity diversified fund categories, along with the three main benchmarks.

Performance Across Market Cycles

Fund Category	Bear Phase	Bull Phase	Bear Phase	Bull Phase	Bear Phase	Bull Phase
	08/Jan/08 To 09/Mar/09	09/Mar/09 To 05/Nov/10	05/Nov/10 To 20/Dec/11	20/Dec/11 To 03/Mar/15	03/Mar/15 To 25/Feb/16	25/Feb/16 To 13/Dec/16
Value Funds	-53.4%	88.1%	-25.9%	29.5%	-19.2%	26.5%
Large-cap	-53.0%	76.0%	-24.3%	26.2%	-20.7%	21.0%
Multi-cap	-56.8%	80.6%	-26.6%	28.5%	-18.5%	25.3%
Mid-cap	-63.9%	106.0%	-28.0%	38.2%	-16.4%	27.7%
Small-cap	-62.2%	107.0%	-30.1%	42.3%	-11.1%	30.3%
Benchmark
S&P BSE SENSEX	-55.3%	76.7%	-25.1%	23.2%	-22.4%	15.4%
S&P BSE 200	-59.0%	84.4%	-28.5%	25.0%	-21.1%	20.2%
S&P BSE MidCap	-68.5%	108.9%	-38.0%	27.6%	-13.9%	29.3%

Data as on December 13, 2016
Returns over 1-Yr are compounded annualised
(Source: ACE MF, PersonalFN Research)
As exhibited by the table above, value funds have outperformed the benchmarks in both the bull and bear periods. And if you noticed, the outperformance is prominent in a rising market. A greater number of funds too, outperformed the benchmark in the bull periods. In a bear market, while they did plunge, the degree to which they fell was far less compared to small cap and mid cap funds, and was almost in line with the benchmarks.

As value funds do not have a market-cap bias, the returns of schemes were in line with the multi-cap scheme category. But during a bear market phase, value funds were slightly better equipped to curb their losses vis-à-vis multi-cap schemes.

How have value funds fared on rolling returns?

Fund Category	1-year	2-year	3-year	5-year	7-year	10-year
Value Funds	2.4%	14.2%	20.1%	13.3%	16.3%	12.8%
Large-cap	-0.3%	10.1%	15.1%	10.8%	13.0%	10.9%
Multi-cap	2.3%	14.6%	19.6%	12.8%	15.0%	11.8%
Mid-cap	5.3%	21.8%	28.8%	18.8%	21.9%	14.4%
Small-cap	10.0%	28.3%	36.5%	21.9%	23.8%	12.9%
Benchmark
S&P BSE Sensex	-3.6%	4.3%	10.2%	7.9%	10.8%	9.0%
S&P BSE 200	-0.6%	8.4%	13.2%	9.2%	12.0%	9.7%
S&P BSE MidCap	8.4%	11.8%	21.3%	10.5%	11.7%	10.2%

Data as on December 13, 2016
Returns are on a rolling basis and those depicted over 1-Yr are compounded annualised.
(Source: Ace MF, PersonalFN Research)
On rolling periodical returns, value funds have outperformed the benchmarks by a significant margin overall. In almost all the periods, the value fund category outperformed large- and multi-cap schemes. In a bull market, mid- and small-cap schemes rally the most, outperforming all fund categories. However, as seen in the table above, mid- and small-cap schemes have been the worst hit in a bear market.

So, who should invest in value funds?

Based on the above analysis, value funds should form a part of your portfolio, if you're seeking decent returns with a lower volatility as compared to mid- and small-cap funds. But you might have to stomach high risk.

Value funds usually do arrest the downside in a bear market, and reasonably outperform in a bull market. Therefore, such market corrections are a good opportunity to start investing in these funds. Before investing in any mutual fund, it is imperative that you consider the long-term track record and analyse the potential of the funds to generate higher risk-adjusted returns.

PersonalFN believes you should not base your decision on myopic speculation.  Instead, focus on the long-term, keeping your investments aligned with your financial goals. Invest in equity schemes only if you have high appetite for risk. Consult your financial planner or investment adviser for a suitable allocation to value funds. In a volatile equity environment, it is best to opt for Systematic Investment Plans (SIPs); that would help you mitigate risk.

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