Don’t write off value investing

Many money managers in India talk about value investing, but very few really practise it. In the last five years, their numbers have dwindled even further, as value investing strategies have lagged growth-based ones by a mile.

Data from Bloomberg show that, as of September 30, 2015, the annualised return on the MSCI India Value Index, a benchmark for value investors, was at a negative 0.44 per cent for five years. During the same period, the MSCI India Growth Index managed a 9 per cent annual gain.

The recent run has prompted a good number of money managers to assert that value investing doesn’t work in India and they have packed their portfolios with high PE (price-earnings) stocks that offer good earnings visibility. But history shows that it may be foolish to write off value investing so summarily. Here’s what a study comparing value and growth strategies, over a 20-year period, shows.

Growth versus value A little bit on what differentiates the value and growth styles of investing first. Value investors believe in buying businesses that are going for a song in the market. They buy stocks that are trading at a deep discount to their intrinsic value, using metrics such as a low price to book value, a discount to replacement cost, a high dividend yield and so on. Their credo is that it is best to buy sectors and stocks when they are out of favour in the markets, as this is what ensures long-term returns.

Growth investors, in contrast, like to buy fast growing businesses, never mind their stock price. They identify businesses that are growing ahead of the industry and if they unearth such a stock, they don’t mind a high valuation.

It’s cyclical

Taking stock of the growth and value strategies in the Indian market over the last two decades, it is clear that the two strategies outperform in cycles. If the last five years have been a torrid time for value investors when their stock picks struggled, they enjoyed their place in the sun the five years before that.

Value stocks notched up huge out-performance in the bull market from 2005 to 2009. In that period, the MSCI India Value Index delivered a 26 per cent CAGR, trouncing both the Growth Index’s 15 per cent and the Nifty’s 20 per cent. In fact, assessing how the two contrasting styles fared in the last two decades, there is little to recommend one style over another. The MSCI Value Index outdid the Growth Index in 9 of the 20 years, Growth raced ahead of Value in 10 of those years. The two strategies were neck-and-neck one year.

Today, with growth strategies outpacing value in every one of the last five years (2010 to 2015), the time may in fact be ripe for a swing in favour of value.

When value outperforms So, accepting that the two styles of investing work at different times, what decides the timing? What’s the right time to bargain-hunt and when should you seek shelter in growth stocks?

History suggests that value stocks deliver their best show in extended bull markets. The most long-lasting bull market that India has witnessed in the past two decades was the one between April 2003 and December 2007. The MSCI Value index delivered a breathless 646 per cent gain in those four years. The Growth Index lagged with a 510 per cent gain. The recovery year of 2002, when markets rebounded from the lows of 9/11 also saw value stocks managing twice the gains of growth stocks.

When it lags

But value strategies have struggled to deliver in two situations. Value-based strategies may trail growth-based ones both in the very initial phases of a bull market and also in its very last legs. In the first case, value investors would wait for evidence of earnings growth before betting on stocks.

In the second case, they would be convinced of a stock price bubble and therefore would rush to the exit door quite early. It is noteworthy that the MSCI Value Index (70 per cent) delivered less than a third of the returns clocked by the Growth Index (271 per cent) during the last leg of the tech stock boom between November 1998 and February 2000. However, in the crash that followed, value stocks also suffered far less erosion (minus 43 per cent) than growth stocks (minus 68 per cent).

This should tell you why value strategies have done poorly in the Indian markets in the last five years. Corporate earnings in India, which made quite a spectacular recovery immediately after the credit crisis of 2007-08, began to again falter from 2011.

But even as corporate profits slowed, Indian markets took off from their lows of 2011 on the prospect of political change, and a landslide win for the Modi Government. This has taken up the price earnings multiples of some Indian stocks quite sharply.

But with profit growth still looking dodgy, value investors have tended to either sit out or play it very safe in this rally. They have avoided the pharma, private bank and FMCG that growth investors have flocked to simply because their multiples are quite hard to justify. Stocks from cyclical and commodity sectors such as infrastructure, metals and public sector banks do offer bargain buys, but are not out of the woods on their business yet. Value style funds and managers have handled this challenge mainly by owning high cash or debt positions, while booking profits on richly valued stocks.

This divide in markets clearly reflects in the valuation metrics of the MSCI India Value and Growth Indices too. By end-September 2015, the MSCI India Value Index featured a trailing PE of 18.2 times (forward PE of 13.5) and this was at a discount to the Nifty’s valuation of over 20 times. The MSCI India Growth Index, on the other hand, had a lofty portfolio PE of 29 times (forward PE of 23.5), a huge premium to the Nifty.

Plan of action The above analysis of value versus growth style of investing in India has three clear implications for investors.

For one, if you have packed your portfolio with either stocks or funds that have delivered the highest returns over the last five years, it is probably choc-a-bloc with growth stocks (read the most expensive ones in the market). Given that the growth style has already enjoyed a five-year run of out-performance, there could be a reversal. To benefit from any rebound in value strategies, rebalance to good value style funds or low PE stocks with good fundamentals (this may sound difficult, but there are good low-PE stocks in out-of-favour sectors, such as PSUs, metals and capital goods).

Two, if you own funds with a good long-term record which have underperformed of late, look into their portfolios to gauge if they have value leanings. If they do, hold on. Their time may yet come.

Three, while you should rebalance your portfolio if you have an overdose of high PE stocks, don’t go overboard on ‘value’ until you see a strong recovery in earnings. When India Inc’s profit growth picks up decisively, that would be the time for value investing to make a strong comeback.

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