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The stock market has rallied 40 per cent in a flash; mid-cap stocks have kept pace with blue-chips and the action in small-cap stocks is reaching frenzied proportions, with many of them clustered at the upper circuit limit on any given trading day.

While speculative froth is undeniably building up in one segment of the market, there has been a rational element to how stock prices behaved in this unexpected rebound. Value investing, or buying stocks that trade far below their intrinsic value, has paid rich dividends in the bounce-back from the March trough.

And that’s not a flash in the pan. Our analysis shows that value investing has delivered good results for Indian investors over the long term as well. That contrasts with the popular notion that India is a “growth” market where investors shouldn’t mind paying a high price for alluring earnings prospects.

Value delivers

Consider the stock market surge from the recent low (8100 for Sensex). In the BSE-500 basket, the highest returns have been amassed by stocks with a PE multiple of less than 5. These stocks delivered an average 60 per cent gain between March 9 and now. Stocks with a modest PE below 10 averaged 53 per cent. Both classes of stocks easily outpaced the index return of 37 per cent.

Low PE stocks within each sector have also delivered better gains than their more expensive peers. Tata Motors has zoomed ahead of Maruti Suzuki (75 per cent versus 21), Reliance Communications has delivered thrice the returns of Bharti Airtel and Suzlon Energy has beaten NTPC hollow (65 per cent versus 6 per cent).

All three outperformers are clear instances where investors have bet on a deeply discounted price, brushing aside concerns on near term earnings or business uncertainties.

Further analysis shows that it is not just stock selection based on low PE that has worked. Investors who used other “value” filters — a high dividend yield or a low price-to-book value ratio — were rewarded equally well. Stocks with a high dividend yield (see table) have delivered a 55 per cent gain between March 9 and now, while those trading below their book value have gained 58 per cent.

Method in the madness

This cherry-picking of stocks ties in with the fact that the triggers for this market rebound came from instituional investors returning to Indian stocks. Since mid-March, there has been consistent FII buying and deployment of cash positions by domestic mutual funds and private insurers, even as retail investors cashed out. Institutional investors may have preferred undervalued stocks for two reasons. One, the ongoing slowdown has made it difficult for investors, even institutional ones, to make multi-year forecasts on revenues or earnings of companies. With projections subject to higher uncertainty, it appears safer to stick to stocks which discount only modest growth expectations.

Two, the steep market falls of last year and the 80-90 per cent erosion in some mid- and small-cap names has made investors pay greater attention to downside risk in recent times, leading to a “value” bias.

But is this partiality for low PE stocks a recent trend? Should investors go for less expensive stocks while building a long-term portfolio? While the answer to this question may have been very different during the bull market years from 2003 to 2007, recent evidence suggests that they should.

The market meltdown of 2008 has done much to restore the credentials of ‘value investing’ as a strategy suited to the Indian market. Though India is widely believed to be a growth market where institutional investors seek stocks for their heady growth prospects (and not for their bargain prices), today’s return numbers as of today, tell a different story. After two gut-wrenching market cycles, value stocks today sport a much better long-term track record than growth stocks, having delivered much better returns over 3, 5 and 10-year holding periods.

Compounded annual returns on the MSCI India Value Index (the key benchmark for value-style managers, Source: MSCI Barra) for a ten-year period at nearly 17 per cent, are at almost double the returns delivered by the MSCI India Growth Index (8 per cent).

A ten-year analysis shows that though growth stocks have made the most of the bull markets during their momentum years, value stocks did much better in containing falls during the inevitable reversal.

Given the tendency of the Indian market to swing (without warning) from a bull to a bear phase once every few years, it is the MSCI Value Index that has built up a better long-term track record than the Growth Index, till date.

For equity investors keen to build wealth over the long term, containing losses in a market fall may be as important as participation in upside during a bull phase. The message is, if you are looking at reasonable returns along with a less bumpy ride in the stock market, have a ‘value’ tilt to your portfolio.

Taking the lead

Another reason why investors may be better off owning under-valued stocks in market conditions such as this is that value stocks have usually led the initial leg of a market recovery from a bear phase.

As Indian markets commenced a new bull market after bottoming out in April 2003, the MSCI Value index climbed by 101 per cent in the eight months that followed, while the Growth index rose by just 77 per cent. Value stocks would also have delivered better returns after the May 2004 correction.

Value strategies also posted lower losses than growth-led ones during the vicious downturns in equities. The MSCI India Value index (decline of 42 per cent) fell much less than the Growth index (down 67 per cent) in the aftermath of the dotcom bubble.

This pattern was again repeated in the meltdown between January and November 2008, when the Growth Index plunged by 64 per cent while the Value Index got away with a 55 per cent decline (the US experience has been quite different; see accompanying article).
Add “value”

So what are the implications of the above trends for retail investors looking to rejig their portfolios?

With recent stock price gains driven mainly by re-rating of PE multiples (as the earnings picture remains quite bleak for many sectors), use the recent market rally to book profits in the more expensive stocks in your portfolio. That may also mean reducing exposure to the stiffly valued “defensive” stocks among FMCGs, power generation and pharmaceutical companies. Within sectors, switch to those that are available at less demanding valuations.

While adding cheaper stocks to your portfolio, beware of value ‘traps’— stocks that are trading at a low valuation, but could yet get cheaper as the company’s business or liquidity conditions deteriorate. Stocks of commodity companies (they appear cheap because of a high earnings base, which won’t be sustained), realty companies (who may post sharp profit falls) and the highly leveraged companies appear to be classic value traps in today’s context. If you find selecting value stocks a tricky proposition, take the mutual fund route. Most fund managers in the Indian context tend to be “growth oriented”. But value-focussed funds such as Templeton India Growth Fund, ICICI Pru Discovery Fund and UTI Dividend Yield Fund make a good addition to your portfolio.
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