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FundsIndia explains: What is a value fund?

July 18, 2016 . Mutual Fund Research Desk

If you’re a savvy shopper, you wait for discount seasons during the year to buy that new television, phone, fancy shoes or clothes. You get the same good performance or durability, but for a much lower price. If you look for cheaper prices for good quality while buying a phone and are willing to wait for it, you can do the same thing when you’re buying a stock. That’s a value strategy.

What is it?
The principle of looking for good businesses that are trading cheap is value investing. Theoretically, a stock’s price should reflect the underlying potential in a company. A company’s fundamentals, which are its business strategy, revenue and earnings growth, its management, and so on, determines its true worth or intrinsic value. When the intrinsic value of a company is widely misjudged or not realised by the market, the stock’s price will be below this value. As and when the market realises this potential, the stock’s price will move up. A rerating of a stock (from cheap to good) can reap huge gains.

valueA value investor seeks stocks that are so undervalued. A value mutual fund is therefore one that follows a value strategy. Funds such as ICICI Prudential Focused Bluechip, Franklin India Bluechip, ICICI Prudential Value Discovery, PPFAS Long Term Value, and HDFC Top 200 are some examples of funds that tend towards a value strategy.

Stocks can become undervalued for several reasons – if there is an overreaction to bad news, the sector in which the company operates is in disfavour, if the company is just starting to turn around, or just plain market irrationality (it happens!). 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, earnings metrics such as profit margins, return on capital, return on investment, performance metrics such as asset turnover, credit worthiness and so on.

One has to tread the value strategy with caution as a miss can result in value trap. A stock may appear cheap but for good reason. Such a stock may never move up and you may end up with an opportunity loss as your money could have been deployed elsewhere.

How is it important?
Knowing that a fund is a value one will help you understand its performance. First, a value-based strategy will pay off only over a longer period. It takes time for the market to recognise potential and then lift the stock.

Second, if it is a bull market, then value will well underperform. In such a market, there will be a set of favoured stocks or sectors and these run up swiftly. As a result, they will not be cheap and therefore will not be a part of a value fund’s portfolio. For the same reason, during market downtrends, a value fund will keep losses to a minimum. Since it already holds stocks that are down, they will not fall by much when markets fall.

Third, value requires patience and suits moderate risk investors. If you hold a value fund, you should be willing to take temporary bouts of underperformance. For example, those such as HDFC Top 200, UTI Opportunities, ICICI Pru Focused Bluechip have all shown relative underperformance over the past year. This is because sectors and stocks these funds favoured, such as banking, engineering, or industrials were all out of market favour over 2015 and much of 2016. A preference for quality and earnings visibility by the market, which has been in place for years now, sent valuations of FMCG, pharmaceuticals, automobiles, finance companies and so on through the roof. Value funds may not own these stocks as they are seldom cheap. Consequently, they would have posted lower performance figures.

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