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Are value funds a valuable investment proposition? - Outside View by PersonalFN

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Are value funds a valuable investment proposition?
May 26, 2011

In the equity markets around the world, the term "value investing" is used quite often. But an interesting thought - do all investors really understand the meaning of "value investing"?

Well, this is because all you investors in the sheer excitement created by your broker / distributors / relationship managers, get swayed and indulge in momentum playing rather than investing. All the so called "experts" providing intra-day calls, short-term calls have got you subscribed to wrong habits of gambling rather than investing.

Remember, value investing has a set of investment principles, and not subscribing to them would land you in momentum playing / gambling. Mr. Warren Buffett's flair for investments in equity markets around the world is guided by set of value investing principles which are:

  • Companies should havesound 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 - Yes, this is the most vital point which you often ignore. When invest 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".
Hence by definition too, value style of investing involves buying companies / stocks which are underpriced due to some fundamental reason and are somewhere close to their intrinsic value. Thus while doing value buying for your portfolio, you should be focusing on companies which have are in good lines of business, strong business model; but from a valuation perspective are trading at a low price to book value, low PE multiple but having a high dividend yield.

But the glamorous reporting and short-term analysis done by the business channels today, very often mesmerise you to indulge in trading / gambling which in our opinion in the long-term is hazardous to your wealth as well as health.

Remember while all business channels are interested in getting their TRP rating on the top (which makes them portray the world of investing to be so glamorous), and the stock brokers getting their brokerage (by providing short-term calls); it is for you to decide whether you would like to tag yourself as a trader or a "value investor".

While you may say - "how is it possible for a layman to understand lines of businesses, business models, valuations etc while following value investing?"

Yes sure, we do recognise that truly discovering value stocks can be a daunting task(as it involves extensive research); but you still can hold some wonderful value stocks in your investment portfolio.How? Bysimply investing in the value style equity mutual funds which enable you to take exposure to value picks by providing you the benefit of diversification.

Value style fundstoo by definition pick-up stocks for their portfolio that are underpriced 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.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?
Scheme Name 6-Mth (%) 1-Yr (%) 2-Yr (%) 3-Yr (%) 5-Yr (%) Since Inception (%) Std. Dev (%) Sharpe Ratio Portfolio Turnover Ratio (%) Expense Ratio (%)
Birla SL Dividend Yield Plus (G) -8.0 13.1 48.0 19.8 15.1 30.2 7.96 0.18 14.00 2.27
ICICI Pru Discovery (G) -3.9 10.4 57.6 19.5 12.7 27.1 10.15 0.17 60.00 1.93
ING Dividend Yield (G) -8.1 10.8 50.0 16.4 14.9 16.8 9.21 0.15 80.06 2.50
Quantum LT Equity (G) -5.4 15.3 47.9 15.5 16.9 17.2 8.58 0.15 45.92 1.50
UTI Master Value (D) -6.9 12.6 55.9 14.3 11.6 23.3 10.03 0.12 42.04 2.24
Tata Dividend Yield (G) -4.1 15.3 47.3 13.4 14.9 21.1 8.56 0.12 24.51 2.50
Tata Equity P/E (G) -5.4 8.2 42.6 10.0 15.2 26.1 9.31 0.10 38.26 2.50
BSE SENSEX -6.0 9.0 29.5 3.4 9.7 - 9.69 0.04 - -
BSE-100 -7.6 6.5 31.2 2.8 9.8 - 10.11 0.04 - -
BSE-200 -8.5 6.0 32.8 3.1 9.5 - 10.24 0.04 - -
(NAV data is as on April29, 2011. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period.
Risk-free rate is assumed to be 6.37%)
(Source: ACE MF, PersonalFNResearch)

So far as revealed by the table above, value style funds have delivered appealing performance. Especially over a 3-Yr time frame, the returns have been very impressive, along with the risk being well managed (as revealed by the Standard Deviation). This in turn has resulted in most value style funds generating luring risk-adjusted returns (as revealed by the Sharpe Ratio). Moreover, since the portfolio of most value funds is built on the investment principle of long-term investment horizon (along with the other value investing principles), they also do not indulge in aggressive portfolio churning thus exposing you investors to less risk and a controlled expense ratio.

Portfolio Characteristics and strategy:
Generally to build-up a portfolio too, value style funds look forward to bear or corrective phases of the capital markets and follow a bottom-up approach of stock picking. This is because a corrective phase of the equity markets enables them to buy companies / stocksat attractive valuations (thereby following the value investing principles) for their portfolio. They usually hold the stocks bought during the bear or corrective phase of the market until mis-pricing (in the stocks) gets corrected.

The stock bets taken by value funds can be in various market cap segments (i.e. large caps, mid caps and / or small caps) depending on where and how the fund manager of value funds construes value in them.

Top 10 sectors
Top 10 Stocks
Name of the company % of holding*
Oil & Natural Gas Corpn. Ltd. 3.0
Sterlite Industries (India) Ltd. 2.7
Bharti Airtel Ltd. 2.5
Great Eastern Shipping Company Ltd. 1.9
Cadila Healthcare Ltd. 1.8
Standard Chartered PLC 1.7
Rain Commodities Ltd. 1.5
Bharat Petroleum Corpn. Ltd. 1.5
Tata Motors Ltd. 1.5
Amara Raja Batteries Ltd. 1.4
Note: Sector holdings as on March 31, 2011 of value funds in the peer comparison
table, have been taken for top-10 sector calculation.
Top 10 stocks are also consolidated of value funds in the peer comparison table
(Source: ACE MF, PersonalFNResearch)

Moreover, while taking sectoral bets they have latitude to discover value stocks within a promising sector too, and at the same time be fairly diversified. So for example at the present it is evident from the chart above that the most value funds have taken a dominant exposure to the banking stocks, based on their potential for future earnings and evaluating the fact that we may see further policy rate hikes from the RBI (in a move to tame inflation).

The verdict:
While indulgence in momentum playing can give you a thrill, of creating wealth in the short-term, it can be hazardous to your wealth and health. It is noteworthy that a trader is only good until his last trade. Meaning, it is not necessary that every trading call would create wealth. Moreover by taking short-term bets you may be a victim of cartelization, wherein your stock may just not perform well once the cartel loosens its grip on the respective stock(s).

Hence it is more prudent to invest in companies having strong fundamentals to portray by subscribing to the value investing principles. And even if you don't possess the skills of value investing, you can simply opt to invest in good performing value style funds which can help you to achieve your ultimate objective of wealth creation by exposing you to moderate risk in equity.

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

Disclaimer:

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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