When buying equity funds, do you make your fund choices based on the market-cap category they belong to? If you’re doing this, you may be missing a trick or two.
There’s a big difference in performance even between the funds within each market cap category. All large-cap fund managers, for instance, choose their portfolio candidates from the same bucket of top 100 stocks by market cap. Still, the best performing large-cap fund has managed a 16% CAGR in the last five years while the worst one returned just 7%.
Apart from the fund manager’s skill, a hidden factor that explains such return differences is the investment styles in which each fund is managed. Right now, many of the funds that have managed to top the charts with a 16% return are value-style funds, while the laggards are growth-oriented ones.
Different investment styles of stock picking work during different market phases and it’s important to know the style of the equity funds you own in your portfolio. But most fund managers do not wear their style on their sleeve, so how do you go about gauging the style of the fund manager who’s got your money? Here’s how.
When you go to a mall, do you hunt for brands that have 50% off or a ‘Buy 2 get 3 free’ offer? You have the makings of a value investor.
Old-style value investing was about looking for stocks that trade below their book value, have a low PE compared to their five-year average or a dividend yield that is higher than bond yield. Benjamin Graham, the father of value investing, suggested that value investors also put their stocks through further filters such as high current ratio, low debt and historical EPS growth.
While the idea of buying stocks at a 50% discount to their ‘real value’ may sound appealing, there are many pitfalls to this style.
- Value traps: In a market where smart folks from Ivy League schools are constantly on the lookout for best buys, stocks that trade at a low PE or a low P/BV are often cheap for a reason. The reason could be that the business has an uncertain future, the management is dodgy or that the Street simply doesn’t believe the reported numbers. Buying low PE or P/BV stocks in the later stages of a bull market is particularly dicey because most good businesses have already been unearthed, allowing only duds to trade at a bargain.
- Rear-view driving: Value investors assign a lot of weight to past numbers and historical assets built up by a company, while taking future projections with a pinch of salt. This makes it hard for them to buy companies or sectors that are in the nascent stages of growth and can double or treble in size. Most multi-bagger stocks come from this space.
- Not adapting with times: Traditional value investors focus a lot on hard assets, while dismissing soft ones such as a firm’s human resources, R&D or goodwill and reputation with customers. Yet in recent years, services and tech businesses have create enormous value from soft assets. This obsession with building, land, plant and machinery has made many a value investor miss the bus on technology giants like Microsoft and Alphabet as also new-age consumer platforms such as Amazon or Meta.
In fact, even Warren Buffett, after dabbling in ‘cigar butt’ investing (https://www.ppfas.com/pdf-docs/b-finance/cigar-butt.pdf ) his initial years, moved to a more pragmatic style later, where he bought growth companies at reasonable valuations.
In short, the downside to value hunting is that, after picking up 3 free shirts for 2 paid ones, you may find that none of your 5 bargain shirts is decent enough to wear to work!
Do you like to wear beautifully pressed trousers to your friend’s birthday bash, while everyone’s dressed in distressed cutoffs? You can think of yourself as a contrarian investor.
Investors who follow the contrarian style believe in swooping in on beaten-down companies or sectors, when the market is taking an irrationally pessimistic view of them.
The difference between the contrarian and value investing styles is basically that contrarian investors do not look for stocks trading at cheap PEs or P/BVs on an absolute basis. They focus on valuation dips created by over-reaction to negative events.
Contrarian investors are those who bought into Coal India when it was getting a lot of hate from ESG investors, entered Nestle India at the peak of the ‘Lead-in-Maggi’ controversy or added Infosys to their portfolios after the ruckus about its governance in 2017.
The flip side to being a contrarian though, is that the market may be right and you may be wrong about a company’s troubles. It requires very high conviction to swim against the tide when a barrage of bad news is battering a stock.
When browsing through fashion sites, do you go straight to the brands you love, without looking too closely at their price tags? Then you’re cut out to be a growth style investor.
Growth style fund managers look for companies that can deliver strong growth in revenues and earnings for the foreseeable future. They screen for market leaders in a sector that can expand manifold from its present size or go for relatively small companies that can grow their market share by leaps and bounds. Finding such companies is the holy grail for growth investors – looking at whether they are at a good price, comes later.
Because growth style investors look for high growth and visibility of earnings, they usually tend to spend a lot of time and effort on excel sheets. They model the size of a market opportunity and project likely growth rates in the company’s revenues, profits and cash flows far into the future, to arrive at a Discounted Cash Flow-based valuation for it.
A majority of Indian fund managers, even those who profess to be value investors, are actually growth investors – they focus more on a company’s future earnings, than on valuation.
Yes, fund managers often tell you that they prefer Growth at a Reasonable Price (GARP). But GARP is an oxymoron. Good growth stocks are seldom available at a “reasonable price” especially in bull markets, so growth style managers end up playing the relative valuation game.
There are two pitfalls to growth style investing. One is the tendency to extrapolate a company’s earnings too far into the hazy future to justify its (sky-high) valuation. There’s this analyst who became famous on Twitter as the ‘FY41 guy’ after modelling Nykaa’s earnings until FY41 while rating its IPO a Buy. The anecdote’s here.
The problem with taking excel modelling too seriously is that it gives one a false sense of confidence about a business, when real life events are rarely predictable even a year or two into the future.
A second big problem with growth investors is that their stocks are more vulnerable to hara-kiri in a bear market. Because growth investors typically model high earnings growth with steep valuation multiples, any disappointment on the growth front can lead to a collapse in stock prices, leading to big losses. If you’re in the terminal stages of a bull market, its best to own more value than growth stocks.
Know that feeling when the expensive FabIndia kurta you bought fades into a pale rag after a few washes? That’s the risk with growth investing.
Do you have a friend who doesn’t mind buying a pair of white sneakers from Jimmy Choo at Rs 59,500? Does she try to convince you that a Rs 1.80 lakh Louis Vuitton handbag is worth every paisa because it will last for years? Well, she is a quality-style investor.
Quality-seeking investors believe that there are always so-so, middling, good and GOAT (Greatest of All Time) in the market. They always prefer to own the GOAT companies.
Quality investors put companies through many stringent tests before they are willing to certify them as GOAT. They look for high Operating Margins, Return on Capital Employed and Return on Equity, negligible debt and high free cash flows. They expect the company to grow fast with rare recourse to fund-raising. Usually, only companies that are market leaders in their sector or enjoy a strong moat (edge over rivals) by virtue of strong brands, extensive distribution reach, superior R&D, patent protection or regulatory protections manage to satisfy these conditions.
As you can imagine, companies with such superlative qualities will rarely trade cheap, so quality investors don’t mind paying a hefty premium for their picks. They also tend to believe that their companies are buy-and-hold-forever, giving birth to philosophies such as Coffee Can investing (made famous by Saurabh Mukherjee through his book and Youtube videos. You can catch a video here.
The big risk to quality investors is that they begin to believe too ardently in the invincibility of the companies they own and accumulate their favourites at any price.
But what the market regards as “quality” stocks can change drastically in different markets, and the quality halo around a sector or company can dissipate pretty quickly when regulations or governance concerns intervene. A sector which offers very high margins and shareholder returns can see the entry of new players who beat down prices.
The narratives built around quality companies also go pretty quickly from fact to hype, leading to bubbles building up in such stocks in bull markets. Three-digit PEs enjoyed by Indian software companies during the dotcom boom, and astronomical PEs assigned to some paint, FMCG, specialty chemical and diagnostics companies in the recent bull run are manifestations of investors chasing #QAAP.
Not being fashion-conscious, do you look for safety in numbers and simply buy what everyone’s wearing? Well then, you’d make a good momentum investor.
Momentum style investors believe that, with literally thousands of smart investors fishing for the best stocks in the market, there is wisdom in following the crowd. They prefer to add positions in stocks that are already trending up and trim positions in those that are flailing.
Investors who use technical analysis to identify buys or rely on volume and liquidity indicators, follow some form of momentum investing.
Most index funds in India are actually momentum investors, because they choose their constituents on the basis of market-cap. They raise weights in stocks and sectors that are performing well in the m-cap rankings and chuck out stocks that have been sliding in m-cap.
Bull markets in India have generally lasted far longer than bear markets. This has helped momentum investing score over other forms of investing at most times. But momentum-based stock picks tend to become over-owned in bull markets and suffer big reversals when the tide turns.
Imagine filling your wardrobe with low-rise bell-bottomed pants only to find that they went out of fashion six months ago!
Do you hate shopping? Would you love to have a robot pick your clothes for you, based on the latest market trends, every day? Well, you’re likely to be happy with quant or quantitative investing.
Quant investors believe that humans, with their messy emotional reactions to situations, are the root of poor stock picking. So, they try to do without the human element by using computer-run screeners or programs to buy or sell stocks. They often use back-tested data to build their models. Do note that quant models may in turn use value, growth, quality or momentum filters to pick stocks. But their core objective is to use the same set of filters consistently.
Quant investing does help to take the emotions out of investing. But the investment returns it generates can only be as good as the algorithm used to select stocks, which is written by a real-life person. Quant strategies can ignore qualitative and intuitive factors that go into stock selection (such as management quality). They can also be quite opaque as most quant investors like to keep their ‘proprietary’ screeners a closely-guarded secret.
To sum up
Being able to identify the styles of equity investing can improve your fund choices in three ways.
- Most people are by nature, hard-wired to be value, growth or momentum investors. If you choose a fund which is close to your own preferred style you’re more likely to stick with it through thick and thin.
- As different styles perform in different market phases, you can diversify your funds across styles to smooth out blips in performance. You can also shift tactically between styles based on market conditions.
- Knowledge of a fund’s style can help you better understand periods of outperformance or underperformance, which helps you put the fund’s returns relative to its category or benchmark in perspective.
With Prime Funds, you will see a column called ‘Why this fund?’ where we explain the investing style of the fund and its suitability. Do read this before choosing your fund.