Money Simplified

May 2019

Guide To
Value Investing
With
Mutual Funds

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Guide To Value Investing With Mutual Funds

Disclaimer :

“This does not constitute investment advice. Returns mentioned herein are in no way a gua-
rantee or promise of future returns. Mutual Fund Investments are subject to market risks, read
all scheme related documents carefully.”

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 Guide To Value Investing With Mutual Funds

INDEX

What Is Value Investing? 3

4 Steps to Value Investing 4

What Are Value Funds? 8

5 Reasons to Invest in A Value Fund 9

Tax Implications of Investing in A Value Fund 12

Conclusion 13

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Guide To Value Investing With Mutual Funds

What Is Value Investing?

“Nowadays people know the price of everything and the value of nothing.”— Oscar Wilde

In the stock market or equity investing, it is very common for investors to look at the ‘price’
than the ‘value’ the stock commands. In addition, investors chase stocks that are the talk of the
town instead of discovering their true worth. To put it simply, they chase momentum, but
what they forget to assess is the margin of safety and value proposition, and as a result, end up
buying stocks at unreasonable valuations.

The fact is, it’s important to pay the right price, for the right stocks. This is precisely the famous
quote: “Price Is What You Pay, Value Is What You Get” by the legendary investor, Warren Buffett
popularly called “Oracle of Omaha”, conveys.

Interestingly, the term ‘value investing’ is often used but not all investors understand the mea-
ning of ‘value investing’.

So what is value investing all about? For that, first, understand what is meant by ‘Value’.

In simple terms, it is the worth of your money spent on whatever you purchase. The important
word here is 'worth'.

Investopedia defines intrinsic value as the perceived or calculated value of a company, including
tangible and intangible factors, using fundamental analysis. Also called the true value, the intrinsic
value may or may not be the same as the current market value.

Value Investing is more concerned with business fundamentals than factors affecting the
market sentiment. It is based on the understanding that the in the near term the equity mar-
kets have little to do with fundamentals, and are subject to irrational and excessive price fluc-
tuations due to the ingrained tendency of most people to ‘trade’, rather than ‘invest’. Hence, the
father of value investing, Mr Benjamin Graham, has said, "In the short run, the market is a voting
machine, but in the long run it is a weighing machine."

‘Value investing’ is about knowing exactly what you are paying for today rather than specula-
ting over what you could possibly get in future. And value lies in something available currently
at a discount or at a price lower than its actual worth. Hence, it’s important to understand the
intrinsic value of the business, by forecasting the present value of all future cash flows and
paying attention to ratios viz. Price-to-Book value (P/B), Price-to-Earnings (P/E), Price-to-sales,
Dividend Yield, and evaluating many other parameters.

Value investing also finds its place in the profound quote, "Beauty lies in the eyes of the behol-
der" by the Greek philosopher, Plato. So, value investing is also beyond valuations (the quanti-
tative parameters). It also involves having a sense of the macro picture ––the economy, the
industry, the business of the company, the business model, the management of the company
among many other qualitative factors, and how all of this augurs in the journey of wealth
creation for investors. Are there any steps to value investing? Yes, read on to learn…

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 Guide To Value Investing With Mutual Funds

4 Steps to Value Investing

Step 1: Identifying your circle of competence :-

This comprises all the businesses that you are familiar with and thoroughly understand. For
Value investors, it is important to invest only in businesses that they understand. Value inves-
tors must focus solely on areas of business where they believe they have an edge over the
average investor.

Say, you're a doctor. Being an insider to the healthcare industry, you would most likely have a
pretty good first-hand understanding of the sector. You may have knowledge of various drugs
by pharma companies. An analyst, on the other hand, would not have access to this valuable
information. This puts you as a doctor in an advantageous position. Of course, this does not
mean you are already an expert on pharma companies, however, you are at a great starting
position.

Similarly, many products and services that you use in your daily lives are often listed compa-
nies. As a regular consumer and visitor to the mall, you may have a good starting knowledge
about product quality, pricing, and competitors.
While debt is considered to be safer than equities; equities can help you generate superior
returns. Inclusion of gold would improve the diversification further.

Likewise, staying away from what you don't understand is equally important.

Step 2: A 'moat' to protect your castle :-

If you look at castles, there is one feature which is pretty much common across all of them
–and that is the moat. The feature is a deep trench all around the castle.

In value investing too, you should look to protect your castle. In simple words, you should look
for companies with a sustainable competitive advantage. Larger the advantage, wider is the
moat. This moat would protect the business from the competition. And if the company is able
to use its competitive advantage to widen the moat over time, then it is the perfect business
to be in.

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Guide To Value Investing With Mutual Funds

Do note that companies that have a wide moat are able to earn higher returns for its sharehol-
ders. And it is able to do so consistently year after year, every year. This, in turn, propels its stock
value over the years. The best part about such companies is that they are able to do well even
when conditions are bad.

But how do you identify a stock with a solid moat?

For this, you need to understand how a company can build a moat. The safety moats can be
built by the business in a lot of ways.

1. Brand : A good way for a business to build competitive advantage is by building a brand.
A brand that has consumer recall. It would take years and a lot of investment for another
company to challenge the authority of a good brand.

2. Economies of scale : A good way to look at economies of scale is to think of a company

that can increase its operations without increasing its costs at the same pace. Such comp
nies tend to have a massive size of operations. They have already incurred huge fixed expe
ses. Additional costs that are more variable in nature are not very high.

So, as sales increases, these companies are able to expand their operating margins. The
economies of scale help the company in the form of a moat because for any competitor to
enter the market, it would need to make a huge investment —something that is only poss
ble if it has very deep pockets. And even if it is able to make such an investment, it would
still take time for it to become a low-cost producer, something that economies of scale can
help in. As a result, the dominant company could cut prices to retain its competitive adva
tage. Think of Walmart: The company has been able to reach the size where it is today
simply due to the economies of scale.

3. Switching costs : When you buy a laptop or a computer, more often than not it comes
loaded with the Microsoft operating system. Have you ever thought about changing the
operating system? The answer would most probably be no. Why? Because there is a cost
involved. This is what is called a switching cost.

High switching costs make it costly for a customer to switch from one product to another.
Or from one company to another if a company is able to create this moat, then it ends up
having a customer following without the threat of competition. Switching costs create a
barrier of entry in a way that deters competition.

4. Patents : A great way to build a moat is to simply patent the product. If the competition
has to enter, then it has to wait until the patent expires. Or will have to buy the patent from
the company. Typically, pharma companies have been able to build such moats.

5. Monopoly : Being in a unique or niche business makes for a good way to create a safety
moat. Being the only company in the area means that there is literally no competition.

But there is something important to note here. The company should not be a monopoly in a
business that has demand. However, this advantage is something that needs a lot of work to
be sustained. The higher returns that a monopoly earns can and does end up attracting
competition. Therefore the test for the company is whether it can defend its competitive
advantage over long-term.

These are just some ways to identify safety moat of a company. Other ways include creating
network effects, having cheaper access to raw materials, government regulations that favour
one company over another are among others.

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 Guide To Value Investing With Mutual Funds

The bottom line is that the company should have a competitive advantage. The advantage
should help it generate superior returns over time. And the advantage should ideally be
growing over time. If the moat is too tiny, then competitors can easily cross it over time. So
safety moats need to be getting wider and/or deeper as the years go by. And if you find such a
company, then make sure you invest in it when it is available at cheap valuations. Such an
investment can help you earn superior returns in the long-term.

Step 3: A word about management :-

Perhaps among various factors that need to be looked at before investing in a company, the
management is the most important.

But that is also where the difficulty lies. After all, how do you assess management? Unlike
company financials, ratios and valuation methods which can be quantified and expressed in
numbers, management quality is a subjective aspect. No number can be assigned to it. And
yet it is one of the most crucial elements in value investing.

There are three main factors in assessing management:

1. The results of the company
2. The treatment of the company's shareholders
3. How well it allocates capital

Let us discuss each of these...

1. Results : Past performance is indicative of how well the management has been able to
steer the growth of the company. This is through both good times and bad. Indeed, a good
management needs to be proactive and should have the ability to respond to changes,
competition, opportunities and threats. Having said that, what needs to be noted is that the
management track record has to be evaluated in the context of the sector dynamics in
which com panies operate.

2. Treatment of shareholders : Shareholders obviously stand to benefit if the managment

has been able to provide healthy returns on capital and dividends on a consistent basis.
Return on invested capital and dividend yields are some of the important parameters to be
looked at while determining whether a shareholder is getting the most of what he has put
into the company.

3. Allocation of capital : How effectively the management is able to allocate capital is a

very good indicator of its quality. For instance, one needs to evaluate whether this capital is
being invested in projects or activities in line with the company's overall growth strategy.
Moreover, are these investments generating good returns? If the capital is not being inve
ted, then whether the same is being distributed to the shareholders.

Management strength at the end of the day is a qualitative factor. So, as an investor, you need
to have a grasp of the people at the helm of affairs before you decide to buy stocks. This would
mean reading annual reports, analysing company performance and keeping a check on the
management's communication with the shareholders. This may not be as concrete as num-
bers, but it certainly helps in forming a reasonable judgment on what the management's
objectives are, and what it intends to do to drive company performance going forward.
Step 4: Valuations :-
The last step pertains to valuations. It is most important of all the steps since valuations decide
the action points (buy or sell) for investors.

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Guide To Value Investing With Mutual Funds

How to estimate intrinsic value?

Determining value is a tough task. That's because it involves forecasting future cash flows
which in itself is a challenge. Discounting those cash flows at an appropriate rate gives us an
estimate of value.

However, forecasting cash flows for a business is not easy because of the uncertainty involved
with the future, unlike coupon bonds. Valuing coupon bonds is relatively easier since you
know the coupon payments of the future. But that is not the case with equities (the business).

So, basically, the mantra is to look out for businesses that resemble coupon bonds. This would
make the valuation exercise easier. In other words, businesses, where forecasting future cash
flows is relatively easier, are the ones that should be on your radar as an investor. Once you
have the estimate of cash flows, discount it with the appropriate interest rate and compare it
with your purchase price. The decision then needs to be taken accordingly.

How to predict the cash flow of cyclical businesses?

The legendary investor, Warren Buffett, is of the view that for cyclical business the estimates for
cash flows have to be conservative. Also, since he focuses on long-term investing, the discount
rate used is constant across securities. And that figure is arrived at by using government bond
rates. An appropriate premium over that and you are on the right track. No complicated finan-
cial models like risk premiums, sensitivity analysis, scenario framework and betas, just simple
logical mathematics.

Word on relative valuation

Warren Buffett is not a big fan of relative valuation because of his focus on cash flows. None-
theless, if used, appropriate relative multiples need to be taken into account to understand the
return generating capability of the business like shareholder returns - return on equity, return
on capital employed etc.

How to estimate growth rates?

Forecasting future cash flows involves an estimate of growth rate. The mantra here is to be
conservative. If the growth rates are higher, then the estimate of intrinsic value will increase.
And investment decisions are based on comparing the intrinsic value with the market price.

Thus, your estimate of intrinsic value has to be as accurate as possible. High growth rates make
the intrinsic value more susceptible to changes. Hence being conservative pays off.

Margin of safety

The concept of margin of safety is the essence of valuation. Since the estimates of intrinsic
value involve subjective judgments, there is a possibility of being overly optimistic. The margin
of safety provides a cushion by adjusting the optimism from the forecast. Say, for example,
your estimate of intrinsic value is Rs. 100. Taking into consideration a margin of safety of 20%
you can adjust the value to Rs. 80. This will ensure that you do not overpay for any asset.

If you feel value investing is exhaustive but wish to have exposure to stocks purchased using
value investing principles and strategies and would like a professional fund manager to do the
daunting task, consider investing in worthy value funds.

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 Guide To Value Investing With Mutual Funds

What Are Value Funds?

Value funds are diversified equity schemes that follow a value style of investing. Meaning,
stocks are picked for the fund’s portfolio based on value investing principles and strategies
discussed above.

According to the capital market regulator’s categorisation norms for mutual funds, a mutual
fund house can offer either a Value Fund or a Contra Fund, not both. This is because ‘contra
investing’ is a sub-set of ‘value investing’. In a contra fund, the fund manager does not necessa-
rily limit his/her buying decision to the intrinsic value of the company but also takes contrarian
bets going against the market perception. This is the fundamental difference between contra
and value investing.

Value investing, on the other hand as mentioned earlier, involves identifying fundamentally
sound stocks near to their intrinsic value. So, the fund manager of value fund practices value
investing principles and strategies for the portfolio construction activity and usually uses a
bottom-up approach to stock picking. Moreover, he/she could have exposure across market
capitalisation i.e., large-cap, mid-cap, and small-cap stocks, and sectors.

As per the regulatory guidelines, Value Funds need to follow value investment strategies and
maintain a minimum 65% investment in equity & equity related instruments.
Return Potential

Risk Level
Note: The above chart is for illustrative purpose only.
(Source: PersonalFN Research)

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Guide To Value Investing With Mutual Funds

On the risk-return Value Funds find are placed relatively high – between Focused Funds and
Divided Yield Funds. Hence, value funds aren’t for the faint-hearted. If you are an aggressive
investor, willing to moderate-to-high risk, and have an investment time horizon of at least 5
years, you may consider owning a Value Fund in your core portfolio.

To identify the best value funds, avoid relying excessively on past performance. Do keep in
mind: past performance is not indicative of future returns. Hence, if you are investing in
top-performing schemes of the past, anticipating that they will be top performers of the
future, you may be proved wrong.

Here are a few mistakes to avoid while you pick a Value Fund:

Giving undue importance to returns generated by a scheme during bullish phases

Depending extensively on the past track-record of a scheme

Not considering the track record of the scheme in handling downside risks

Giving importance to the short-term market outlook

Relying blindly on star-ratings

Disregarding qualitative aspects associated with mutual fund selection

Ignoring your personalised asset allocation

Relying on the advice given by friends and relatives who are unqualified to give you
advice on mutual funds

Remember, managing a value fund is no cakewalk. It requires the fund house to have a deeper
understanding to ascertain whether the investment will be truly valuable or a dud in the long
run. It also requires, at times, the courage to go against the market and take bold calls.

Hence, careful selection matters a lot. If you select a worthy Value Fund, it might pay-off effec-
tively in the long run.

5 Reasons to
Invest in a Value Fund
So, here are 5 reasons to invest in a Value Fund:

1. Follows disciplined research and investment process

Usually, most Value Funds adhere to the guiding principle of ‘value investing’ for their portfolio
construction activity, as they endeavour to stay true to their name.

Value is not only a softer aspect of the organization but how the fund house invests while it
perceives ‘value’ when assessing both, quantitative as well as qualitative aspects of the stock/-
company in consideration for the evaluation process.

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 Guide To Value Investing With Mutual Funds

2 . Use bottom-up stock selection approach to minimize the risk

Value Funds typically follow a bottom-up approach to stock picking, where the company’s
fundamental aspects viz. its overall competiveness and potential are evaluated first, and then
the sector, and industry it operates in, the prospect of it and the overall macroeconomic envi-
ronment are evaluated.

Macro
Enviornment

Industry

Sector

company

Bottom-up

( Note: For illustration purpose )

The entire approach entails identification of companies that have a good management team,
good product line, high growth potential, and cheaper valuations compared to its peers.

Making sound decisions based on a bottom-up investing strategy means gaining a thorough
review of the company in question. And therefore, the fund management and his team also
make it a point to meet company managements, before taking any investment decision.

To pick stocks, the fund manager evaluates:

- The business of the company

- The environment in which the business operates

- The management of the company and their long-term goals

- And can the financials support the long-term growth

The investment decisions are pronounced on the fundamentals of the company and its ability
to cope with changing undercurrents–be it the sector, industry, the macroeconomic economic
conditions–and the growth potential the company offers.

In addition, the company under consideration is analysed based on fundamentals relative to

their peers by weighing Price-to-Earnings Ratio, Price-to-Book Value Ratio, Dividend Yield,
Present Value of Cash Flow (PCF), and the Enterprise Value-to-EBITDA.

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Guide To Value Investing With Mutual Funds

A Value Fund could discover value bets in the mid and small-cap domain, or even larger com-
panies that could be beaten down but still hold the value proposition considering the finan-
cials and the qualitative aspects of the company under consideration. Moreover, a Value Fund
is usually sector agnostic.

In the portfolio building exercise, value style funds look forward to the bear or corrective
phases of capital markets and follow a bottom-up approach in stock picking. This is because a
corrective phase of the equity markets enables them to buy companies/stocks at attractive
valuations (thereby following the value investing principles) for their portfolio. That said, it also
requires, at times, the courage to go against the market and take bold calls.

The aforesaid investment approach followed by a Value Fund is aimed at mitigating the risk
involved.

3. Holds cash when stocks are overvalued

The fund managers keep a close watch on market valuations and make efficient use of cash to
safeguard the portfolio when valuations look stretched. This means a Value Fund could go
overweight on cash if the valuations are extremely high and gradually switch to equities as
they correct.

The strategy helps investors benefit from value buying more during market corrections, which
potentially proves rewarding in the long run.

4. Low portfolio turnover

A Value Fund does not indulge in aggressive portfolio churning; the portfolio is held with
conviction with value investing being the core.

The fund managers of a Value Fund buys each stock with a long term view and follow buy and
hold investment strategy to derive the full potential of the stocks in the portfolio. This, therefo-
re, results in a low portfolio turnover for the fund.

5. Can help you address your long-term financial goals

If you systematically invest in a Value Fund, it can help you accomplish the long-term financial
goals such as buying a dream home, your child’s higher education needs, their wedding
expenses, and even your own retirement.

However, selection is the key. Managing a Value Fund is not cake walk. It requires the fund
house to have a deeper understanding to ascertain whether the investment will be truly valua-
ble or a dud in the long run.

Therefore, it is important to choose a Value Fund that has consistent performance track record
and comes from a mutual fund house that follows robust investment process & systems, and
has in place effective risk management strategies.

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 Guide To Value Investing With Mutual Funds

Tax Implications Of
Investing In A Value Fund
A Value Fund is classified as an equity scheme from a taxation angle.

1. Follows disciplined research and investment process

Both long term and short term capital gains tax are applicable. Here the short term is categori-
sed as a period of upto or less than 12 months. And the long term refers to any period of more
than 12 months.

STCG (or Short Term Capital Gain) tax charged on gains of units held for upto or less than 12
months is @ 15% (plus applicable surcharge and health education cess).

LTCG (or Long Term Capital Gain) tax, on the other hand, is on gains of units held for more than
12 months and for LTCG in excess of Rs 1 lakh. The LTCG tax rate is @ 10% without indexation
benefit. However, relief is granted to investors to the extent of capital gains as of January 31,
2018 (the cut-off date). So, the amount of gains made after this cut-off date will be taxed.

Though the tax liability will have a bearing on your post-tax returns, considering the past
performance and the future potential, it could be a rewarding experience to invest.

Please note that if you opt for the dividend option, the dividends are tax-free in the hands of
individual investors. But remember that dividends are paid after levying a Dividend Distribu-
tion Tax (DDT) @ 10% (plus surcharge and health education cess) on equity-oriented mutual
fund schemes.

If your goal is to grow your wealth, choosing the dividend option would end up eating away
the accumulated profit at regular intervals. Dividends are often touted to be a benefit as it is
tax-free income; however, dividend pay-outs get in the way compounding.

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Guide To Value Investing With Mutual Funds

CONCLUSION
Owning a Value Fund in your core portfolio is a sensible thing to do. But before you go ahead,
do take note of the following:

- Make sure you have the stomach for moderate-to-high risk;

- Recognize what is your investment objective and if it’s in sync with that
of the fund

- Consider your financial goals before investing;

- Set realistic return expectations

- And have an investment time horizon of at least five years;

If you decide to invest in a Value Fund/s, prefer direct plans and invest through the SIP route.
This can help you mitigate the volatility (with rupee-cost averaging) and power your invest-
ments with the benefit of compounding. Pick your funds carefully while you endeavour to
create wealth.

Sound risk management strategies are of the utmost importance for a fund house offering
value style funds. Quantum Long Term Equity Value Fund is a worthy value fund that truly
follows a value investment strategy while focusing on long-term growth. By focussing on
stocks that are trading at a discount to their intrinsic value, this value-oriented scheme has
lived up to its name, picking undervalued stocks (across market capitalisations and sectors)
that have the potential to deliver supernormal returns over long-term. This makes QLTEVF a
prominent contender for long-term investors looking for a relatively stable fund that can add
true value-style flavour in their portfolio. That said, consult your investment adviser to assess
if the Fund is suitable for you.

Happy Investing!

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 Guide To Value Investing With Mutual Funds

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