Value Funds. Do You Have The Patience To Hold?
Value investing is something which is adopted by many successful investors like Warren Buffett and this is the style of investing which is adopted by value funds as well. DSIJ evaluates and explains value funds as a sub-category of equity scheme and what should be your approach towards them.
The confluence of various factors, including economic policy and geopolitical developments, is making equity market nervous and undecided. In the last six months, issues such as moderation in GDP growth, increase in surcharge and trade war between world’s two largest economies have led investors to be risk-averse world over. So, where should an investor seek protection in the current market situation? When you face such situations, history should be your guide and it suggests that value investing has worked in these uncertain times.
The value investor works like a shrewd buyer who makes the most of the end of season sale. These investors come out with their wish list and go out on a shopping spree. Chances are high that they would get quality products at lower prices.
In the investing world, the fund manager of an equity value fund builds portfolio of stocks that are available at cheap valuations. The lower price may be due to various reasons. It may happen that the true market value of a stock is widely miscalculated or not realised by the market and hence the share price is trading below its intrinsic value. However, as and when the market realises its potential, the stock will be re-rated and the its price will move up and, thereby, the investors can reap huge benefit.
This is just the opposite of growth funds, which typically invest in high growth companies from the sunrise sectors. Investors easily get convinced by the growth of these companies and hence get attracted towards these growth funds. While it is true that they do generate returns by investing in well-accepted growth funds, they also run the risk of paying too much for too little.
The basic purpose for which you invest is to create wealth through capital appreciation, and for many investors, growth funds become the logical choice. However, in the field of investment, there are various legendary investors such as Benjamin Graham and Warren Buffett who have multiplied their capital several thousand times by adopting value investing strategies. Value investment is actually what you are paying for today rather than speculating over what you could possibly get in the future. And value lies in something available currently at a discount or at a price lower than its actual worth.
Does this mean that value investment has always performed? If yes, under what conditions the value funds have performed better? Over the years, what is really striking is the value fund’s ability to perform in the long run. In the short run, they tend to underperform, but in long run, they tend to generate better returns.
Value funds in different market conditions
Value investing makes a lot of intuitive sense as it is no rocket science to understand that it is always better to buy a cheap stock rather than a pricey one. Nonetheless, these funds do not perform always in all market conditions and are subject to major performance swings. There were times in history when value investment performed so badly that many short-sighted commentators predicted the death of value investing. This was the time when the tech stocks were on tear and many old-age industries such as industrial manufacturers, basic material producers, etc. found themselves left out in the cold. Anecdotal evidences suggest that many of the money managers who specialised in value investing folded up or just retired.
Nonetheless, they returned with a vengeance after the collapse of the new-age stocks. They not only outperformed the market, but even recovered the lost ground. In many of the previous market downturns, value funds have lost money just as growth funds have, but they are the first to perform when the recovery begins. They were the fastest to recover and outperformed the other categories. The latest being the period between 2004-2007 when growth stocks and growth-dedicated funds dominated the investing world. However, following the fall in the Indian equity market in the year 2008 and the recovery thereafter, value funds performed better and recovered the fastest.
Our analysis of the yearly returns of the value funds point towards this. We checked the yearly returns of growth funds and value funds since 2008 and found that the value funds have performed better than the growth funds when the market recovers from its low. For example, in the year 2008 when the frontline indices fell by more than 50%, growth and value funds too dropped by similar percentages. Nonetheless, in the year 2009, when market recovered and Nifty gained by 75.76%, the average returns generated by value funds were 100.72 per cent, while growth funds generated returns of 85.41 per cent. The story was again repeated in 2014 after the lacklustre performance of equity market in 2013. The value funds in 2014 on an average generated return of almost 60 per cent, when the frontline index generated return of 31 per cent.
What is also interesting is that when the overall market falls or generates lower returns, the value funds fall more than the growth funds and the market. For example, in 2018, when Nifty went up by 3 per cent, the value funds dropped by 8.17 per cent as compared to 7.17 per cent for growth funds. The best part is that the difference in the performance between growth and value funds widens when the market is rising, while it narrows when frontline indices fall.
The Trailing Returns
When it comes to trailing returns, we see that in the short run, the value-oriented funds tend to underperform the other categories of funds. However, in long run, these funds tend to catch up with the remaining market. For example, in the last one year ending August 6, 2019, value-oriented funds generated negative return of -12.34 per cent, as against average return of around -10% by other categories. Nevertheless, as the investment horizon increases, these funds tend to perform better than the other categories of funds. For example, in the 10-year period, the value funds on an average generated return of 12 per cent, which is marginally above the average returns generated by other categories.
Rolling Returns
The above returns are for one period, that is, for period ending August 6, 2019 for one year, three-year, five-year and ten-year returns. This may not truly reflect the trend and hence we studied trailing returns of the above period covering almost 1250 data points.
The results are not different from what we obtained in the above study.
In the one-year period, we see that the difference in the returns between Sensex and average of value funds are not great and, depending upon the market condition, they beat each other.
In the three-year period, the value funds have largely beaten the frontline indices. However, during deep market downturn, they tend to outperform the market. When it comes to five-year period, these funds are the clear winners. As we increase the investment horizon, the value funds tend to perform better. One of the reasons for such performance is it takes time for investors to recognise the value in a stock and, hence, in a three-year period and beyond, these funds tend to perform better.
You must be wondering why stocks are available at cheap valuations. There are several reasons. There are cases where the market or the investors give a knee-jerk reaction to some bad news or the sector in which the company operates is out of favour or the company is just starting to turn around, or just plain market irrationality. In every case, the stocks are available below their intrinsic value, which helps value fund managers to generate superior returns. Investors use a combination of several metrics to judge whether a stock is undervalued – price metrics such as price-to-earnings, price-to-book, enterprise value, dividend yield, and earnings metrics such as profit margins, return on capital, return on investment, performance metrics such as asset-turnover, creditworthiness, and so on.
How value fund is defined by SEBI
After the rationalisation and categorisation of the funds done by SEBI in 2017, a fund house can offer either value fund or a contra fund. They cannot offer both types of funds. According to the circular, the scheme should follow a value investment strategy and the minimum investment in equity and equity-related instruments should be 65% of the total assets.
Why to bother about type of funds
Although it seems quite obvious that when you buy a fund with an investment horizon of 20 years, it will be different from the fund that you are holding for 5 years. Nonetheless, in everybody’s portfolio, whatever may be the holding period, there should be a couple of equity funds that should form the core of your holdings. Value funds are the ones that should form a part of your core holding. Our analysis of trailing returns of value funds shows their robust performance in the long term horizon. These are funds that are diversified across sectors and stocks. They might not invest in small-caps and new-age economy stocks, but they invest largely in large-cap stocks. Some of you might argue what is the reason for investing in large-cap stocks when it is generally the small-cap stocks that generate superior returns in the long run. Small-cap stocks are volatile and hence may not be suitable for your core holdings. Your core funds should be less volatile and large-cap stocks should form the core. Moreover, about 70% of the Indian stock market is constituted by the large-cap stocks in terms of market cap. Hence, any investor is likely to compare performance of his equity portfolio with equity indices. Therefore, these large-cap stocks should form part of your portfolio and thus value funds should form part of your core holding.
Risk Statistics
Returns are important, however, the risk taken to earn those returns is equally important. Hence, we studied the risk statistics of the value funds and compared it with growth funds. We observed that the best part with the value funds is that they offer lower beta and higher alpha. Our study of last one year returns shows that value funds have better risk statistics than the growth funds (excluding index and ETFs). Beta of the value funds on an average have remained at 0.55 compared to beta of 0.93 for growth funds, while the alpha for the growth funds is -1.63 compared to 2.77 for value funds. This shows the smoother investing experience of value fund investors. Hence, the fund looks more suitable for investors who are risk averse and have long term investment horizon.