All investors want to buy best performing mutual funds. It is not possible to predict the future and so investors go with past performance when selecting mutual funds in the hope that a fund which performed well in the past, will perform well in the future too. Many mutual fund investors and financial advisors may have read the disclaimer that past performance may not be indicative of future performance, but I have seen that the vast majority of investors and financial advisors base their fund selection on past performance, that too recent past performance. If you are a long term mutual fund investor, you may have seen that funds which were top performers for one or two years before you invested, underperformed later. You might have blamed your luck or your financial advisor for the underperformance.
I have also noticed that, many investors and financial advisors are now also looking at star ratings or rankings for selecting mutual funds for investments. Star ratings given by reputed research firms are better indicators of fund’s performance potential because they are based on a number of factors. But star ratings do not guarantee future outperformance, because past performance (last 3 years or 5 years) is an important parameter (with the maximum weight) in star rating methodologies of many research firms.
Some investors may want to ask, how will they select best performing mutual funds for investment without using past performance because past performance is the only data they have. Past performance can give investors very useful information, but smart investors also look at other factors like volatility, performance in down markets and fund manager investment style. You should note that, even these factors may not guarantee best performance (on a relative basis) in the future, but analyzing all the factors will help investors form good expectations of their fund’s performance in the future. Among the different factors, the fund manager’s investment style is one of the most important factors because it has an impact on the different performance parameters like returns, volatility, beta, alpha etc. In this blog post, we will discuss about two different investment styles, with particular emphasis on how these two styles have done in the Indian context.
While some of our regular readers may know about investment styles, for the benefit of all our readers, there are two styles of equity investing:-
Growth Investing: In the growth investing style, fund managers focus on companies where they expect higher than average revenue and earnings (EPS) growth. Since the EPS of growth stocks grow faster benchmark (e.g. Sensex, Nifty, BSE – 100, BSE – 500 etc.) EPS, the market reward growth stocks with higher prices.
Value Investing: In Value Investing style, fund managers try to identify companies which are trading at prices which are significantly below their fair price. In other words, value investors invest in companies, which they are believe are undervalued. Value investors seek stocks with lower than average Price to Earnings (P/E ratio) or lower than average Price to Book (P/B ratio) or higher than average dividend yields.
Investors who are new to mutual funds may not always know whether a fund manager follows growth investment style or value investment style. Mutual Fund scheme names can give investors clues with regards to the investment style. But investors should also look at the product literature, scheme information document or the AMC website to understand the investment style. Mutual fund research websites also has information on investment style for individual schemes. In Advisorkhoj, we often interview fund managers and investors can refer to those interviews to get a sense of the investment style.
Value versus Growth investing in the US
The legendary investor, Warren Buffet, is the most famous practitioner of value investing style. Warren Buffett has consistently beaten index funds for a long period of time and has created huge wealth for him and Berkshire Hathaway investors through value investing. In the west, especially the US, many investment experts consider value investing to be a superior style compared to growth investing. Since 2000, value stocks in the US outperformed growth stocks in 9 years out of the last 15 years (please see the chart below).
Source: Bank of America
I have seen that, there is a growing legion of Warren Buffet and value investing fans here in India. At the same time, there are experts who say that, value investing may not work as effectively in India, as it does in the US due to a number of factors. Before we delve further into whether growth or value investing works better in India, investors should understand that, either one of the investment styles cannot outperform the other on a consistent basis. You can see that, in the last 10 years growth stocks outperformed in certain years, while value stocks outperformed in the other years. If you had invested in growth funds, you may be disappointed in the years when they underperform. You should know that, there is nothing with your fund selection because there will be years when your fund will outperform. Same will apply, if you invest in value stocks. Knowledge about growth versus value investing will help you form expectations better and thereby, plan better.
What works better in India – Growth or Value?
In order to look at how the two different investment styles have worked in India, we have analysed the returns of two MSCI (Morgan Stanley Capital International Index) indices - growth index versus a value index over a long time period.
You can see that from 2005 to 2012, the value index outperformed the growth index in most years. However, post 2012, growth index has outperformed value index. In the last 5 years, MSCI Growth Index has given 12.35% annualized returns, while MSCI Value Index has given only 8.7% annualized returns. The chart below shows the growth of Rs 1 lakh invested in MSCI Growth Index versus Value Index over the last 5 years (please note that, we have used year end index values in this chart).
You can see that, MSCI Growth Index outperformed MSCI Value Index over the last 5 years. But how have the two indices fared on a relative basis over a much longer time-frame? The chart below shows the growth of Rs 1 lakh in MSCI Growth Index and MSCI Value Index over the last 13 years (please note that, we have used year end index values in this chart).
You can see that, the growth of Rs 1 lakh over the last 14 years has been almost the same in Growth Index and Value Index. However, for most parts of the last 14 year time-frame, value index outperformed.
What does this data tell us?
Let us refer back to the annual returns chart of the indices. 2004 to 2008 was a great bull run for stocks in India. When valuations appeared to be rich, especially in 2006 and 2007, the Value Index outperformed. When the market crashed in 2008, the growth stocks suffered more than value stocks. Even when the market recovered in 2009, value stocks outperformed. However, from 2010 onwards growth stocks outperformed. There is a saying in the stock market that, price runs ahead of earnings growth. While valuations (price) and earnings go hand in hand, there can be short term distortions. When valuations become a concern, value stocks tend to perform better (see the period from 2005 to 2008). On the other hand, when earnings growth is the most important concern, then growth stocks are rewarded (see the period from 2013 to 2017). In an investment cycle, we will see both and therefore, there will times when growth stocks will outperform value stock and vice versa.
Momentum chasers and value traps
Price appreciation of a stock does not make it a growth stock. True growth investors look at Earnings per Share (EPS) growth. If you are chasing price appreciation, then you are a momentum chaser and chances are that you may suffer badly in a market correction. At the same time, just because the P/E ratio of a stock is low, it does not mean that, it is a value stock. The price of a stock can be low, simply because earnings growth potential is low. If you simply invest on the basis on low P/E ratio, you run the risk of getting caught in a value trap (the P/E ratio can remain low for a very long time).
Fund manager alpha should be the most important factor in investing
Whatever the investment style, the objective of an equity mutual fund investor is capital appreciation over a sufficiently long investment horizon. Based on your risk appetite, you can either invest in growth funds or value funds; downside risk is somewhat limited in value funds, because a value fund manager buys underpriced stocks. Over a long investment horizon, both growth and value funds can give good returns. Growth funds can be more volatile, while value funds can underperform for a long time (till valuation re-rating takes place). But over a long investment horizon, the alpha (excess over risk adjusted benchmark returns) generated by the fund manager, makes a substantial difference to wealth creation.
In this blog post, we discussed about growth and value investing, particularly in the Indian context. Investors should not have any pre-conceived notions with regards to superiority of one investment style over the other. In fact, many mutual fund managers employ both the styles to generate consistent returns as well as high alphas for investors. Armed with the knowledge of growth versus value investing, mutual fund investors should be able to form better expectations about how their investments will perform in different market conditions. Most importantly, irrespective of fund investment style, patience and discipline are the two most important virtues in equity mutual fund investing.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.