Value investing is back with a bang

After failing quite miserably in the sideways market of the last four years, value investing strategies have made a big comeback in this bull-run.

This is plainly evident from the equity funds that have made the most of this rally. Funds focussed on value strategies, such as Birla Pure Value Fund and ICICI Pru Value Discovery Fund, are at the top of the rankings with returns of 40-70 per cent in the last six months.

Reckoned from September last year when this rally started, the MSCI India Value Index is up 30 per cent, delivering well over two times the gains in the MSCI Growth Index, which is up only by 13 per cent.

The market’s returning fancy for low-value stocks is also reflected in the gainers list. Classifying all NSE-listed stocks based on their price-earnings (PE) multiple in September 2013, stocks which languished at a single digit PE have boomeranged the most. These stocks are up by 82 per cent between September 1 last year and now.

Stocks with PEs between 10 and 20 have averaged a 67 per cent return. The most expensive faction of the market — the over 20 PE stocks — have returned 55 per cent.

The stellar performance of low PE stocks isn’t surprising, because every recent bull market in India has seen value stocks outpacing growth stocks in the tear-away phase of the rally.

As the markets took off in 2007, the MSCI India Value Index delivered a 61 per cent gain over the year, while the MSCI India Growth Index straggled behind with a 37 per cent gain. Value stocks again managed an encore as the market bounced back from their deep abyss of March 2009. By the end of 2010, growth stocks were up 95 per cent, but their value peers were a full 11 percentage points ahead at 106 per cent.

The bounce-back in value stocks this time around is likely to be particularly sharp because of the market’s obsession with safety over the last four years.

With the economic downturn stretching on, policy glitches holding back new investments and interest rates on a relentless rise, investors have sought shelter in utterly safe bets — companies with predictable, even if low, profit growth, those with no debt and those in sectors with little correlation to the economy. But this high risk aversion had resulted in a sharp polarisation in the market, with the ‘safe’ stocks moving into an unjustifiable premium irrespective of their prospects, while cyclicals and rate-sensitives moved into a deep discount, without much regard to their fundamentals.

As investors rediscover their appetite for risk, this polarisation is correcting, leading to defensive stocks under-performing and the cyclicals bouncing back.

This is good news for investors, as it means that the markets may now be eager and willing to look at good stock ideas from cyclical, but fundamentally promising sectors and from the mid- and small-cap spaces, which were completely out of the reckoning for the last four years.

For investors wishing to join the rally now, value-investing strategies will continue to work quite well. They can either bargain-hunt for the relatively low value stocks or buy equity funds which unearth such stocks on their behalf.

But investors should also note that while value all stocks are usually inexpensive, not all cheap stocks offer ‘value’. This is certainly something that the market has lost sight of, in the excitement over this bull-run.

In their frantic hunt for bargains so far, investors have indiscriminately pegged up PEs for companies with negligible or negative cash flows, those having great difficulty in servicing debt and those which require sizeable policy or regulatory intervention to resume operations. Why, even governance concerns, which used to have investors shying away from some of the prominent businesses, have been forgotten.

Now, while the out-performance of true ‘value’ stocks may well continue, it is best that retail investors don’t take their chances with stocks which are merely cheap, at this point in time.

With most cheap stocks now trading at a much higher PE than just six months ago, they will soon be expected to deliver the results to justify the re-rating. If the quarterly numbers or the policy triggers are long in coming, the price of disappointment can be quite severe.

From here on, therefore, unearthing ‘value’ in the stock market may no longer be about blindly homing in stocks trading at the lowest PEs. Fundamental factors such as demand drivers, profit growth and return on equity will matter as much.

After all, if it is value one is looking for, the denominator should matter quite as much as the numerator.