Once you have ascertained a fair amount of exposure to equities, depending on your financial goals, your next step is to choose the right equity mutual fund.
Your equity fund managers have the option to invest your money in:
A Growth fund: that holds fast-growing firms commanding high prices (growth stocks),
A Value fund: that holds slow-growth firms trading at bargain-basement prices (value stocks),
a mix of both
But how is that important? All you need a 'great' equity mutual fund, right?
Unfortunately, it is not that simple. To understand what makes a fund tick, you must first recognise and understand the different types. The types of holdings explain the past performance of the fund, allowing you to set realistic return expectations.
Types of Funds explained
A Value Fund style
Funds that invest in value stocks:
Often referred to as bargain hunters, value stocks are fundamentally strong companies trading at a deep discount to their fair value.
That trade at a discount due to the market’s overreaction to some problems in the company. Examples include disappointing earnings, cyclicality, negative publicity, legal issues etc.
A value investor stands to benefit once the company bounces back or overcomes any of these issues. The probability is high as these companies are fundamentally strong.
The discount to the fair value acts as a buffer. So on the off chance, things don't work out, your loss is minimised. Therefore, value stocks carry limited risk and are relatively safe.
Growth Fund style
Funds that only invest in fast-growing stocks. Think of it like investing in stocks driving in the fast lane.
Stocks of businesses that enjoy strong growth in earnings. The kind that is significantly above the general market growth rate.
Generally, these businesses are unproven, often related to a hot new product or service (a classic example is a Tech or a Pharma company trying out a hot new product).
Owing to their multiplying earnings, they command a relatively high valuation in the market. Investors are willing to pay more for such companies, owing to their tremendous growth. And if this growth sustains, these expensive valuations might seem justifiable in the future.
Since there is no buffer (as you are paying a lofty valuation) and you are only betting on a new, unproven business model, your investment risks are high.
Usually don't pay dividends as the profits are re-invested for further growth.
Let’s outline some of the key parameters of a Value stock vis-a-vis a Growth stock.
Mostly mid to large-cap
Largely small to mid-cap
Lower than fair value.
Generally available at a higher valuation
Basis for assigning value
Do value and growth strategies work well in a specific type of market?
Value-style strategies generally work better when investors are skittish or concerned about economic weakness.
As a value investor, you do your due diligence and assign a value (discount to the fair value of the business) to the stock, primarily based on fundamental research. No matter how the market adjudicates the company, you do not budge from your position. Your decision is driven only by the value you have assigned, which is the bargain price.
Now this works beautifully in a falling market. You have bought the company at a discount, effectively creating a buffer. And hence your portfolio does not fall much, especially in comparison with other styles.
But this style does have its pitfalls. As the markets rise and get expensive, you, a value investor will suffer. In a bull market, the price tag you assigned is not available anymore. So, you can't invest, as it is against the principles, and are therefore unable to take advantage of the market frenzy.
So, it's safe to say that the value style of investing will realise its full potential only when invested over the long-term. And is so best suited for investors with long-term financial goals.
While a value style strategy underperforms in a bull market, a growth style strategy works well. This strategy enables you, growth investor, to take advantage of the market frenzy, where earnings are rising and valuations are expensive. You, a growth investor, do not fixate on the discount to the fair value logic. And so, you are happy to pay a higher price for growth. This allows you to invest at high valuations and ride the bull market, making supernormal profits.
But this inclination towards high growth will cost you once the market cools off. Since you are paying a high price without any buffer, the total value of your investments will fall more than the value style stocks.
If you were to look at this chart, you will see what is perhaps the shortest bear market in history and a bull market within a few months.
This chart depicts the price movement of the value (green and orange line) and growth (purple and yellow line) stocks. Notice how the value stocks don’t fall much compared to the growth stocks. But when the markets rally, the value stocks didn’t rise as much.
Source: yahoo finance
Knowing how these styles function in different market conditions can only prepare you.
Investors must not choose their style depending on market movements. As you can't time the markets, it is a futile exercise. Till date, no one has predicted market movements successfully at all times.
A better approach is to choose one based on your risk-return appetite. So,
What type suits you best?
It all boils down to your risk-return appetite. The type of fund you choose value, growth or a mix of both even, is defined by your risk appetite and your return expectations. So, for instance, you are saving for a goal like your child’s education some fifteen years down the line. Now this implies that your risk appetite is higher and you can build a portfolio of growth funds. But if you are looking to save for a home in the next 7-8 years, your risk appetite is relatively lower, and so your money will be safer in value funds.
But what if your level of risk appetite is somewhere in the middle? Build a portfolio with a mix of both; value and growth stocks. The value style will bring stability and the growth style, that bit of alpha in your returns for your investment portfolio.
Irrespective of the style (value or growth) you chose, ensure that you:
Invest regularly: to capture returns at all points in time. A study revealed that you lose more money trying to time the market. And so, it is far better to remain invested at all times.
Invest with confidence: don’t get carried away by a swaying stock market. Your investments are only a function of your financial goals.
Stick to a Long-term view: Keep a 5-year horizon. History tells us that a good investment strategy takes time to play out, making patience your most important virtue to become a successful investor.