Should you consider value funds during the current uncertain environment?
Value funds are open-ended equity schemes that follow a value investment strategy. They have to invest a minimum of 65% of their total assets in equity and equity-related instruments.
Almost a year ago, in October 2021, the Nifty 50 index hit an all-time high of 18,604. Since the start of 2022, there has been a lot of uncertainty due to events such as the Russia-Ukraine war, supply chain disruptions, high inflation, central banks increasing interest rates, FPIs selling Indian equities, etc. All these uncertain events have made markets, which are near all-time highs and trading at high valuation levels, vulnerable to corrections. When such times arise, value mutual funds are a good investment choice. This article will focus on understanding value mutual funds, the investment philosophy they follow, the returns they have given, and their taxation.
What are value funds?
As per SEBI’s categorisation of mutual fund schemes, value funds are open-ended equity schemes that follow a value investment strategy. They have to invest a minimum of 65% of their total assets in equity and equity-related instruments. So the next question that will come to mind is, “What is value investing?”
Value investing philosophy
Value investing involves identifying shares of companies that are trading below their intrinsic value or fair value. It means these stocks are under-priced or trading at a valuation lower than what they deserve. The value investing strategy was first used by Benjamin Graham. Currently, many investors, including the legendary Warren Buffet, use the value investing strategy.
A value investor buys under-priced stocks in the hope that going ahead; the market will realize the potential of these stocks. Eventually, the real price discovery of value stocks happens, and the early investors benefit. However, sometimes value investments may become value traps. In such cases, the problems of the under-priced company may initially be hidden but eventually come out, and the share price may fall further.
Understanding value investing with Reliance Jio – Bharti Airtel - Vodafone-Idea tariff war saga
Let us understand value investing with an example. In the second half of 2016, when Reliance Jio launched its cellular services at low prices, there was a big price war between Jio and the incumbent players: Bharti Airtel and Vodafone-Idea. As Jio unveiled rock bottom tariffs, Bharti Airtel and Vodafone-Idea had to lower their tariffs. As a result, their revenues and profitability fell and it led to a big fall in the share prices of Bharti Airtel and Vodafone-Idea.
At that time, the incumbent players Bharti Airtel and Vodafone-Idea fell out of favour with investors. Their shares become unpopular and undervalued (as compared to their earlier valuations). Some long-term investors saw value in Bharti Airtel and bought its shares, while some investors saw value in Vodafone-Idea and bought its shares.
Bharti Airtel was able to withstand Jio’s competition in a better manner. Over time, Airtel was able to improve its profitability. Accordingly, its share price also recovered. Thus, the value investors who bought Bharti Airtel shares during the fall benefitted and made good profits.
Chart: Bharti Airtel price performance
The above chart shows how the Bharti Airtel share price was subdued during the period 2015-17. Later, as the company improved its financial performance, the market started rewarding it with the share price going up.
Vodafone-Idea also faced competition from Reliance Jio, similar to Bharti Airtel. But, Vodafone-Idea was not able to withstand the competition like Bharti Airtel. Over the years, the financial performance of Vodafone-Idea has deteriorated. Losses have been mounting year after year. Presently, the company is struggling for survival.
Chart: Vodafone-Idea price performance
The chart above shows how the Vodafone-Idea share price has been trending down since 2015. It has been one of the biggest wealth destroyers.
So, to conclude, both the telecom companies went out of favour with investors when Reliance Jio launched its telecom services. Value investors who invested in Bharti Airtel made good profits. However, for value investors who invested in Vodafone-Idea, it turned out to be a value trap.
Evaluating companies for value investing
The mutual fund manager may use various valuation methods for evaluating companies for value investing. The most popular method is the Discounted Cash Flow (DCF) model. A company's intrinsic value is calculated using the DCF model by estimating the current value of the company's future free cash flows.
Intrinsic value using DCF model = Current value of future free cash flows
Apart from the DCF model, the fund manager may use various valuation parameters to evaluate companies for value investing. Some of these include:
- Price to earnings (P/E) ratio: Useful for evaluating profitable companies
- Price to book (P/B) ratio: Useful for evaluating financial companies (banks and NBFCs)
- Debt to equity (D/E) ratio: Useful to evaluate companies that are in capital-intensive businesses (for example, infrastructure, metal companies)
- Return on equity (ROE): ROE measures the company's profitability in relation to its shareholder's equity. It is usually useful to evaluate debt-free companies in sectors such as FMCG, IT, etc.
Returns given by top value funds
Let us look at the returns of the top five value mutual fund schemes.
|Scheme name||AUM (Rs. in crores)||1-year||3-years||5-years|
|ICICI Prudential Value Discovery Fund||24,693||18.10%||25.11%||14.86%|
|Nippon India Value Fund||4,507||10.35%||23.06%||14.37%|
|UTI Value Opportunities Fund||6,670||6.93%||21.69%||13.91%|
|IDFC Sterling Value Fund||4,685||16.23%||28.14%||13.38%|
|Templeton India Value Fund||705||20.01%||25.68%||12.18%|
Note: The above returns are as of 26th August 2022. The returns are for direct funds with a growth option. The one-year returns are absolute. The three and five-year returns are CAGR. The funds have been ranked based on five-year returns.
The above table shows how the top five value funds have given five-year returns in the range of 12-15% CAGR, which are good returns.
Taxation of value funds
Value funds have to compulsorily invest a minimum of 65% of their total assets in equity and equity-related instruments. Hence, they are taxed as equity mutual funds.
- Short-term capital gains (STCG) tax: If you sell the value fund units within twelve months of purchase, the profits will be termed short-term capital gains (STCG). The STCG will be taxed at a flat rate of 15%.
- Long-term capital gains (LTCG) tax: If you sell the value fund units after twelve months of purchase, the profits will be termed long-term capital gains (LTCG). In a financial year, the first Rs. 1 lakh LTCG will be exempt from taxation. The incremental LTCG will be taxed at 10% without indexation benefit.
Value investing is a strategy used by legendary investors such as Benjamin Graham and Warren Buffet. These investors have created a lot of wealth for their shareholders using this investment strategy. It is an investment strategy with a proven track record of delivering good returns over time. Hence, you may consider allocating a certain percentage of your investment portfolio to value mutual funds to benefit from it.
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