Categories To Ride For Better Returns

We are still in the mid of a bull market. Different categories of funds have performed differently in varied cycles of the market. DSIJ explains where the market is right now and which categories of funds you should bet on. 



The market has its own mood which even a seasoned investor cannot assert, understand and predict precisely. Just a couple of weeks back, the market was in a free fall and frontline equity indices witnessed one of the longest streaks of fall in their history. The indices fell for nine consecutive days from April 30 to May 13, 2019. Before this fall, there were only four instances when the Sensex in its history of 40 years had fallen consistently for nine days. There were various reasons being touted for the fall. Analysts and investors attributed the decline to the fallout of trade war between the world's two largest economies, slowdown in the Indian economy reflected in all the major parts of the economy be it consumption, investment or export and slowdown in the earnings revival.

Nonetheless, all the fall of those nine days was recouped in a single day of trading. Thanks to the exit polls that predicted the return of the NDA government. The frontline indices gained the most. In absolute terms, Sensex gained 1421 points on May 20, 2019, which is second only to the gain of 2110 made 10 years ago. The broader market indices saw a far better recovery. For example, Nifty Mid Cap saw one of the best ever gain. Similar was the case with Nifty Bank index, which touched new high.

This gain had boosted the net asset values (NAVs) of the mutual fund schemes. On an average, the NAVs of the domestic funds (excluding international funds category) increased by 3.15 per cent. Some of the funds has witnessed their NAVs increasing by more than five per cent and the highest gain posted was 5.75 per cent.

Following table shows the categories that have gained the most.



Will this extraordinary gain of one day give wings to the current bull market? [A bull market is usually defined as a continuous increase in stock prices (based on the index's closing price) without dropping more than 20 per cent from its peak]. If yes, which are the sectors an investor needs to ride in this bull market and gain the most?

To answer this question, we have analysed the situation from three perspectives. First, which stage of the bull market we are in and which are the sectors or themes most suited in these times. Second, we did a empirical study to understand how different sectors have performed when market recovers. Finally, we studied how investing in higher beta funds may not be a wise decision.

A Lethargic Bull
The frontline indices like BSE Sensex and Nifty 50 are still technically in a bull market. (The broader indices and some of the sectoral indices may be witnessing a bear market). It has been a bull market since February 2016. The current bull market is the longest in the Indian stock market history. Going by the technical definition, the market is in a bull phase for the last 807 days. However, this bull market also has the notorious distinction of giving one of the lowest monthly returns. On an average, the monthly return generated by the bull market is 3.12 per cent (since 1986). However, if we take the median return, it is 1.18 per cent. The current bull market has generated mere 0.63 per cent return every month. One of the reasons for such low return is the high level of volatility witnessed in this phase of the market.



Most of the gain that we have witnessed in this bull phase has come through re-rating or expansion of price-earning multiples of indices. For example, for Nifty 50, the PE ratio has increased from 18.65 times at the end of February 16, 2016 to 27.8 times at the end of May 15, 2019. Hence, of all the gain made by the frontline index between this period, almost 88 per cent has come through expansion of price-earnings multiples and only 12 per cent has come through rise in actual earnings.

Therefore, most of the next round of gains will come from the rise in earnings. Taking a broader perspective, the business cycle of the emerging economies is still behind developed economies and is at a mid stage. Unsurprisingly, the business cycle influences the rotation of stock market sectors and industry groups. Certain sectors perform better than the others during specific phases of the business cycle. Knowing the stage of the business cycle can help investors position themselves in the right sectors and avoid the wrong ones. Though the developed markets, excluding the US, are entering the middle stage of business cycle, the emerging economies like India are at the late or early stage of the mid-cycle.

It has been observed that consumer discretionary, industrials, capital goods, cement and financial are likely to perform better going ahead. Therefore, fund dedicated to these sectors or funds with major exposure in these sectors should form part of your portfolio for the next couple of years. Cyclicals are also likely to do better.

The empirical study
To know which sectors you need to be in order to ride the current rising market, we did a study on how the market reacts post a major fall and which sectors rebound the fastest. Our study covered the last two major falls and the rebound in the market. We studied in the fall of performance sector during the bear phase and the sector wise rise in the performance till the end of that year.

Year 2000-01

The first study was done for the period during February 2000 to September 2001. During this time, the market fell by almost 56 per cent, which is second only to the fall that we saw during 2008-09. The fall also coincided with the dotcom crash, where many tech companies went bust. The following table clearly shows how the dotcom impacted the IT-dedicated funds. On an average, these funds lost 70 per cent of their value between those periods.

Following this period of fall, we see that the funds to rebound the fastest are also from the IT sector. Although, the market was technically out of the bearish phase, it continued with the lacklustre performance due to the heightened global instability due to the terrorist attack on the twin towers of the World Trade Centre in New York and their collapse and the subsequent attack on Afghanistan by the US forces. This kept the equity market volatile. In such volatile market, the IT-dedicated funds, which were the worst performers, contained their losses and remained among the top three performers. The multi-cap funds that again remained the worst performers, saw a rebound in their performance in the following one year. The defensive pharmaceutical sector continued its performance.



Year 2008-09

This was one of the worst periods in terms of stock market performance, where the frontline indices such as Sensex and Nifty 50 fell by almost 60 per cent from their peaks. The broader market saw a much steeper fall. This had direct implication on the performance of mutual fund schemes. The sectors that were the worst performers were mid-cap, IT and infrastructure.



When the market rebounded from end of March 2009, the sectors that performed the best were those that were beaten the most. For example, IT sector funds, which had lost more than half of their value during January 2008 and March 2009, more than tripled in the following one year.



The above analysis clearly shows that the funds that have underperformed or have witnessed one of the worst falls are likely to outperform when the market bounces back. If we look at the recent performance of different categories of funds, we find that small-cap, mid-cap, power and infra are the worst performing sectors. Hence, we believe that if market bounces back from hereon, these categories of funds will definitely have edge over others.

High Beta Funds

It is a common belief that the higher the beta, higher will be the returns during the bull phase of the market. This may be true for individual stocks; however, we do not find such correlation for the mutual fund schemes. To understand this, we plotted the returns given by the funds in the last one year against the beta of the fund one year back. We could not say with confidence that higher beta funds performed better than the lower beta funds. For example, JM Core 11 Fund, one of the large-cap funds, had a beta of 1.35 at the end of December 2017. Its return since then is 5.4 per cent. Compare this with Sundaram Select Focus Fund that had a beta of 0.94 and gave a return of 11.4 per cent. Similarly, UTI Equity Fund, the multi-cap fund having beta of less than one, performed better than the funds in the same category with beta greater than one. Therefore, you should not go for funds with higher beta to gain from the rise in the market.

Ride On These Categories of Funds

Despite being in one of the longest bull markets, there is still a lot of steam left for sure. By the time you read this story, probably a strong government would have been formed at the Centre, which will provide higher momentum to the market and further accelerate the returns. Therefore, going by the current stage of the market, investors can get superior returns by investing in funds dedicated to sectors such as infrastructure, capital goods, consumer discretionary and industrials. Along with this, small-cap and mid-cap funds are also likely to outperform other market cap categories in the next couple of years.

Nevertheless, before investing in these categories, you need to be sure that the risk associated while investing in the above categories matches your risk taking ability. Moreover, it is important that you stay true to your overall asset allocation mix, which is a combination of your long-term investment goals and inherent risk appetite.

In the short run, the market is "a voting machine, in the long run, it's a weighing machine." Considering that we do our living in the short run, we must learn to focus our investment gaze on the long run.

- Warren Buffett