Why value funds aren’t strictly going by valuations

What’s wrong with value funds?

Over the last several years, the rally in the equity markets narrowed as investors focused primarily on high-growth stocks, and shares of high-quality firms despite trading at high valuations. So, value stock picking as a strategy got left behind. But, as earnings visibility got lower and after the pandemic struck, uncertainty around corporate profitability only got worse.

Value investing, in simple terms, is a strategy of stock selection where investors actively look for stocks where the current market price does not represent the fundamentals of the company. In other words, the stock trades at a price lower than its intrinsic value, as analysed by investors.

While this strategy fared very well between 2000 and 2010, it has lagged significantly in the last 3-5 years. The table below shows that value funds haven’t been able to beat the Nifty 50 returns over the medium term.

Also read: PPFAS Mutual Fund: A success story in value investing

How value and growth differ

As the risk-reward ratio for value stocks seemed to turn unfavourable, investors and even fund managers seemed unwilling to stick their neck out for value. Of the 17 schemes listed under the Value category on Value research, 15 have Infosys as part of their top 5 stocks and 12 have HDFC Bank too. A majority of the value schemes stocks that are typically regarded as high growth stocks with high valuations occupying at least 30-50 percent of their portfolios.

There is one school of thought, which suggests that both value and growth style of investing are parts of the same branch. The idea is that value stocks bear not just a low price-to-earnings or price-to-book ratio; the intrinsic value of the stock is lower than its current market price, thanks to some unique competitive advantage it may have. In such a case, it could be a company with visible earnings growth and even a high valuation.

Also read: Neither value nor growth, but only quality investing is best-suited for retail investors

With limited opportunities in a polarized market, including such stocks in a value portfolio may seem acceptable. However, that doesn’t mean anything can fit into a value investing philosophy.

According to Vikas Gupta, chief investment strategist, Omniscience Capital, “Value investing doesn’t mean you can’t own stocks in a growth trend. If your cash flow assumptions are conservative and the stock is available significantly below its discounted cash flow valuations, then it’s still within the value investment principle. It’s when you continue to hold despite high valuations, that the company ceases to be called a value pick. That’s when you are deviating from your mandate. Undoubtedly, it is becoming challenging to apply the value philosophy in this market.”

There’s one more way in which value funds may hold up stocks that, to many other investors, may appear to be growth companies. Gupta says, “Mutual fund schemes often align closely to an index. Usually, portfolios are positioned as underweight or overweight versus the benchmark. Some straying from the value strategy may happen as a result of this approach as well.” As a result, the current portfolio may have more stocks with high valuations, as momentum favours those and the ultimate idea for a mutual fund scheme is to deliver returns.

Which value perspective do you like?

The other glaring aspect is the divergence in returns across these schemes. In the last 10-year period, the best performing fund beat the worst performer by nearly 6 percent points. This is a big gap over a period of 10 years. Why?

Beauty lies in the eyes of the beholder. What constitutes a stock’s intrinsic value depends on assumptions and earnings projections made. This can differ among investors and fund managers. One fund manager or investor’s value stock may not be another’s preferred pick.

Also, every stock with a low price-earnings ratio is not a value pick. For example, it may be that the low valuation is justified, thanks to vulnerability to regulations or high levels of debt in the balance sheet.

Value investing no longer depends on one or two ratios. It calls for a deeper analysis of opportunities and the potential earnings growth trajectory. “For investors it’s best to consider a fund from the perspective of how it fits in their overall portfolio. The idea of holding more than one fund is to take advantage of diversification in portfolios and investment styles. Hence, avoid two schemes that have lot of common stock holdings,” says Kaustubh Belapurkar, director, fund research, Morningstar Investment Adviser India.

Should you sell your value funds?

It has been a long time since value funds have given meaningful returns. While some fund houses claim that the time value-styled investing has come, especially as we look forward to a post-COVID-19 world, the question is: how much patience is left with investors stuck with underperforming value funds for a long time.

A simpler approach may well be to stick to a large-cap diversified fund where the fund managers follow a value strategy, without actually calling them value funds. These schemes, anyway, come with the objective of maximizing long-term returns. But trying to choose between two schemes – one that is specifically called a value fund and another that says it follows a growth strategy – might be confusing.