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Is it a good idea to invest in value funds now? - Outside View by PersonalFN

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Is it a good idea to invest in value funds now?
Jan 30, 2015

As you might be aware, Indian equity markets are now one of the expensive markets across the world. It is perceived that phase of sluggish economic growth is behind us and economy is witnessing a phase of consolidation, before it bounces back strongly. Also, pinning hopes on the reform agenda of the Modi-led-NDA Government, investors are betting big on Indian equities.

Investors in Indian equities who invested about 15-18 months back are finding themselves very fortunate to have made huge gains so far. While those who opted to stay out of markets fearing that investment atmosphere may turn worse, have missed the bus and are repenting. And now finding attractive investment opportunities amid times when the Indian equity market has scaled a new high, there is over resistance from those who have missed the bus. Hence PersonalFN has always believed that predicting the direction of the market can be dangerous and thus should be avoided.

Although markets are rallying relentlessly, corporate earnings are not keeping pace with the rise in equity indices. Till now, macro-economic positives such as fall in inflation and favourable monetary policy announcements by the RBI along with pro-business announcements by the Government have pushed markets higher. Likewise, thriving global liquidity is fuelling the current market rally.

But if growth in corporate earnings remains lacklustre and sluggish, markets might eventually correct since valuations have turned unsupportive. In worse case, if global factors too become unfavourable simultaneously, markets may even witness a deeper correction.

So you might wonder where you should invest at this juncture...

PersonalFN believes while Indian equity market has been the beneficiary of global liquidity, it would also be vulnerable to global economic headwinds along with domestic macroeconomic variables. Thus during such times, staggering your investments would be prudent to mitigate risk while your asset allocation plan recommends that you have an exposure to equity. You need to ensure that, you are investing in stocks that are not very expensive and are reasonably priced.

While investing in equity mutual funds it would be wise to adopt the systematic Investment Plan (SIP) route to mitigate risk through rupee-cost averaging which can in turn also power your portfolio with the benefit of compounding. Well-diversified equity oriented mutual funds having an appealing performance track record which is consistent in nature can help you in the journey of wealth creation. At a time when the Indian equity market has scaled a new high, many of you be wondering can value funds be a valuable investment proposition. So here through this article we have evaluated that for you.

What are value funds?

As the name suggests, value funds are a type of equity diversified funds which follow the "value investing" approach. Value funds try to invest in companies which are undervalued as compared to their potential. At most times, if not always, these stocks are out-of-favour and thus are available at attractive valuations. Since these stocks are out of favour, they are often beaten down in the falling market. In the rising market, they rally moderately, or even fall in extreme cases. In principle, value funds invest in fundamentally sound companies but their "out of favour" nature requires them to wait longer to realise gains.

What are the advantages of investing in value funds?

  • Their cautiousness to valuations provides cushion when market momentum reverses

  • Since value funds are not driven by the market momentum, they churn their portfolios less frequently which results in better performance over the long run

  • Usually gains are superior as true value discovery unlocks rewards in a supernormal way
What are the disadvantages of investing in value funds?
  • Since value funds invest in undervalued companies which are like hidden treasures, they take longer than usual to generate superior returns

  • In a rising market if a value fund doesn't find suitable investment opportunities, it might remain under-invested which in turn could result in loss of opportunity if markets ascend

  • Value funds may expose you to higher than average volatility

Should you invest in value funds now?

Having seen the advantages and disadvantages of investing in value funds, you may be wondering whether it is an opportune time to invest in them at this juncture. Well, ideally, value funds do well when markets misprice stocks, which typically happens under intense bull or the bear phase. As we have been experiencing new market highs of late, investing in value funds can be a rewarding. But let's learn more about them before taking a final call.

Value funds in India

PersonalFN analysed the performance of about 20 funds which endeavour to follow the value investing approach. The performance has been a mixed bag over last 3 years. A few funds have outperformed S&P BSE Sensex and S&P BSE 200 by far; but a few others have faltered.

How value funds have fared?
  6 Mths 1 Yr 2 Yrs 3 Yrs 5 Yrs Std Dev Sharpe Ratio
Category Average of Value Funds 20.77 68.59 28.31 26.05 16.55 17.49 0.32
S&P BSE SENSEX 13.77 42.97 21.31 19.70 12.64 15.09 0.23
S&P BSE 200 16.67 50.89 21.87 20.46 12.30 16.65 0.24
Data as on January 29, 2015
Performance of 20 value oriented funds has been considered
Risk-free rate of return for the purpose of calculating Sharpe Ratio has been taken as 7.38%
Returns for 1 year and below are absolute, while those above 1 year are compounded annualised
(Source: ACE MF, PersonalFN Research)

You may be surprised to know that 1 out of every 5 funds has underperformed S&P BSE 200 over last 1 year. Despite that, the category average returns are significantly higher than those generated by S&P BSE 200. This also reinforces that under an intense bull market there is a possibility that a there may be some value funds which may underperform while the other which do very well. Hence value funds as a category are high risk-high return investment preposition as denoted by higher standard deviation and the higher Sharpe ratio in comparison to the S&P BSE 200. The S&P BSE Sensex has clocked similar returns to that of S&P BSE 200, especially over one-year period.

Where are they investing at present?

Value oriented funds follow no cap bias and thus as per the last disclosed portfolio as on December 31, 2014, their exposure to large caps stayed in a very wide range of about 16% to 93%. This suggests that value funds are flexible in their approach and discover value buys across market-cap orientation. But it should be noted that one fund can be totally different to the other, based on the call the investment team takes. This also means careful selection of stocks and sound risk management play a significant role in the success of a value fund.

What value they hold?

Although using a rule of thumb to gauge the value a fund holds would be inappropriate, applying a matrix of a few value indicators would at least tell you how strictly the value oriented approach has been followed.

Since Price to Earnings Ratio (P/E Ratio) is one of the most widely used ratios to meter the value, At PersonalFN we have compared average P/E of value oriented funds against the P/E ratio of S&P BSE Sensex.

P/E Ratio: Value Funds vs. S&P BSE Sensex
Data as on January 29, 2015
Performance of 20 value oriented funds has been considered
Source: ACE MF, PersonalFN Research

As you may clearly see in the graph above, average P/E of value funds has been higher than that of S&P BSE Sensex for most part of the last 1 year. However, you would be surprised to know that the range in which P/E of individual funds has swung over last 1 year has been 10X to 45X. Again, this suggests that value is quite a subjective term and perception of value differs widely from one fund house to the other.

Final verdict:

PersonalFN is of the view that, currently market rally is driven by high optimism and thriving on global liquidity. But unless corporate profits demonstrate substantial improvement, market valuation would appear expensive. This therefore would give chances of a deeper correction until earnings justify valuations.

As far as investing in value oriented funds is concerned, certainly there are merits. Having said this, a careful selection matters a lot to have winning mutual funds schemes in the portfolio. Managing a value fund is not an easy task. It requires the fund house to have a deeper understanding to ascertain whether the investment will be truly valuable or dud in the long run. It also requires at times and the courage to go against the market and take bold calls. However, having in place sound risk management strategies is of the utmost importance for a fund house offering a value oriented fund.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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