Value funds: Invest for style diversification, with 7-year horizon

While value-style funds have performed well post-2020, investors should enter them now not because recent performance will be replicated in the near future but to diversify their portfolios, which are often tilted in favour of growth funds. Only investors with at least a seven-year horizon should consider these funds at this juncture.

 

How do these funds work?

 

Value funds invest in stocks trading at a discount to their intrinsic value. “The price of a stock often fluctuates and goes below its intrinsic value due to multiple factors. A value fund identifies this gap and aims to benefit from this differential,” says Krishna Sanghavi, chief investment officer, equity, Mahindra Manulife Mutual Fund, which recently launched a value fund (new fund offer closes on February 21).

 

Value fund managers believe such mispricing is temporary. “These stocks may be temporarily undervalued due to non-fundamental reasons, such as market sentiment or sectoral underperformance,” says Ihab Dalwai, senior fund manager, ICICI Prudential Mutual Fund.

 

Value fund managers use metrics such as price-to-earnings (P/E), price-to-book (P/B), and dividend yield, comparing a stock’s current valuation to historical levels. They also calculate the intrinsic value of a stock to determine if its price is below this level.

 

Gain from earnings growth, re-rating

 

Fund managers enter stocks at attractive valuations. “These funds benefit from both earnings growth and the business’s re-rating,” says Sanghavi. Both business revival and macroeconomic tailwinds can lift the price of these stocks.

 

These funds invest in stocks that offer a margin of safety. “This helps to lower the risk profile of the portfolio and provide better risk-adjusted returns,” says Shiv Chanani, senior fund manager, equity, Baroda BNP Paribas Mutual Fund.

 

Investing in these funds allows investors to diversify their portfolios. “They include stocks from sectors that may be underrepresented in growth-heavy portfolios,” says Dalwai.

 

Value investing is a proven strategy that has worked globally over long periods. “Many successful fund managers have adopted this approach and generated strong returns,” says Arun Kumar, head of research, FundsIndia. 

 

Beware value traps

 

A key risk in these funds is that the manager could get stuck in stocks known as value traps. “These are stocks whose valuations are cheap for a reason, for example, deteriorating business fundamentals,” says Dalwai.

 

Rajesh Jayaraman, head, product, Nippon India Mutual Fund, points out that value traps could also be stocks of businesses that have been disrupted by technological changes.

 

Sometimes, it can take a long time for undervalued stocks to unlock their potential and deliver returns. As with any style, value funds can witness prolonged periods of underperformance. Kumar notes that value funds struggled between 2016 and 2019.

 

These funds also tend to lag during bull markets, which favour growth stocks. Chanani points out that these funds may miss out on high-growth emerging themes.

 

Should you invest now?

 

The value style has done well in recent times. Nonetheless, fund managers remain confident that the market will continue to offer value opportunities. “Sectoral shifts and macro changes may provide opportunities for the bargain-buying strategy adopted by value funds,” says Jayaraman.

 

Stocks trading at a discount to their intrinsic value are always available in some segment of the market or another. Chanani believes that these funds should be regarded as an all-weather investment theme.

 

Points to heed

 

Despite the recent market correction, overall valuations remain elevated compared to historical averages. Jayaraman, therefore, suggests that investors consider value funds with a longer timeframe.

 

At times, the inherent value-unlocking process may take longer than expected. “Investors must have patience to reap the full benefit of these funds,” says Sanghavi.

 

Timing investment styles is extremely difficult. If you invest in funds of only one style, your portfolio could witness prolonged periods of underperformance. Kumar, therefore, suggests diversifying across multiple styles: quality, value, growth at a reasonable price, small- and mid-caps, and global funds. Doing so, he says, ensures that at any given time, a few styles perform well, ensuring smooth returns from the overall portfolio.

 

Nowadays, factor funds based on value-oriented indices are also available. Experts, however, suggest opting for active funds in this category. “An active fund manager can differentiate between stocks that are temporarily undervalued and those that have structural problems,” says Kumar.

 

When selecting a fund, evaluate the fund manager’s track record. “Ensure that the fund manager has a track record of managing such funds effectively,” says Dalwai. He also suggests reviewing the underlying portfolio to ensure that it holds stocks with sound fundamentals and avoids value traps.