Planning to invest in value funds? Performance hinges on earnings recovery

In 2020, value funds gave investors a sound category average return of 15.1 per cent. The last time these funds had rewarded investors richly was in 2017, when they had given a category average return of 41.6 per cent. The next two years, 2018 (minus 9.6 per cent) and 2019 (1.8 per cent), were disappointing. However, investors who kept the faith have been rewarded this year.

Market preference shifting

Over the past three-four years, growth had got concentrated in a few stocks. As interest rates fell, the limited stocks that could offer growth got rerated to very high levels. In India, the polarisation was exacerbated by events like demonetisation, introduction of the goods and services tax, the non-banking financial company crisis, etc, which hit earnings growth within the broader markets.  

However, a few positive developments have happened over the past few years. Companies have deleveraged their balance sheets. Many have undertaken cost-control initiatives. Many sectors have witnessed consolidation, due to which their leaders have regained pricing power.

Over the past few months, the expectations of a broad-based earnings growth recovery have taken hold. Nifty companies are expected to grow at 10-11 per cent in 2020-21 and 25-30 per cent in 2021-22.

“Due to the expectation of a high growth trajectory, the market has developed the confidence to invest in a broader set of stocks today. This has benefited value stocks,” says Meenakshi Dawar, fund manager, Nippon India Mutual Fund.

The market’s preference has shifted.

“During the pandemic, the market’s preference shifted in favour of companies where the price-to-value ratio was lower, due to preference for current cash flows, compared to those in the distant future,” says Vinay Paharia, chief investment officer-equity, Union Asset Management Company.

Another aspect had to do with expectations of growth. “During the pandemic, growth expectations collapsed. At that point in time, bargain stocks started to look better, compared to growth stocks,” says Paharia.

Attractive valuations are working in favour of value stocks. While many growth stocks are trading at large premiums to their long-term average valuations, many value stocks are still trading on a par or below, offering attractive entry points. “These stocks still offer a lot of scope for price-to-earnings rerating,” says Dawar.

For their good performance to continue, a broad-based earnings recovery is a must. If there is another wave of Covid infection, or interest rates rise due to the threat of inflation, or a global scare emerges, value funds could be hit.

“High risk aversion affects the value theme more because investors flock to safer names,” says Dawar.

What should you do?

Investors must have style diversification in their portfolios.

“It is difficult to estimate which segment — growth or value — will get rerated at what point in time. So, have exposure to both,” advises Paharia.

Be patient with these funds.

“Value funds tend to perform in steps. It is possible that when a value fund underperforms for a couple of years, an investor could get frustrated and quit. Value stocks could start getting rerated just after he leaves,” adds Paharia.

Enter them with a long investment horizon.

“Invest with a 7-10-year horizon. Allocate 20-30 per cent of your equity portfolio to them,” says Vishal Dhawan, chief financial planner, PlanAhead Wealth Advisors.