Approaches to how Equity Mutual Funds invest your money?

This is a question that many mutual fund investors have in their mind. How do fund managers decide what stocks to buy and sell and how do they execute them? What are the approaches that they follow to allocate to stocks, themes and sectors? Broadly, there are 4 key decisions that fund managers need to take when they allocate money to equities. These 4 decisions form the cornerstone of how they allocate your money across stocks. The final portfolio that you get to see in the MF disclosures has a series of decision steps that lead to the final portfolio. Here are 4 of them…

Macro versus Micro approach:

One of the first decisions that a mutual fund manager has to take is whether to focus on the broad macros or the micro details. In a trending market, macros are good enough. You can be certain that if you buy a quality stock and hold it for a reasonable period of time, you are bound to achieve above average returns. The period between 2004 and 2007 was a classic macro play. Most quality stocks, irrespective of which sector they belonged to, gave above normal returns. The fund managers did not have to worry too much about specifics of stocks. Once they got the macros story and trend right, the stock returns would follow.

Post 2008, the markets have become a lot more micro-driven. For example just a handful of companies like Eicher, Britannia, Lupin, TTK Prestige etc have outperformed in this period. The focus was extremely stock specific and specific stocks that could scale up their business models with minimal debt only managed to outperform. To understand this little better, if a fund manager had taken a macro call on a PSU bank or a capital goods company in 2010, he would still be sitting on deep capital losses after 5 years. The primary job of a fund manager is to decide which of these approaches will work.

Top-down versus bottom-up: 

This is essentially an extension of the previous argument. The only difference is that in this case you do not take a macro call. Only the approach begins from a macro standpoint. For example before zeroing in on a stock, the top-down approach dictates that you ensure that the economy is in good shape and growing. Then the fund manager has to satisfy himself that the industry in which the company is operating has good prospects and can deliver profit growth. Finally, the fund manager zeroes in on the specific company that is expected to outperform the other stocks in the sector.

The bottom-up approach, as the name suggests, focuses on the specific company first and foremost. Once the company is identified, the focus shifts to the industry and macro level factors. But in this case, the macro and industry factors are not used as decision points. They are merely used as ratification points. Take the case of Eicher Motors. While most auto companies may have underperformed post 2009, Eicher outperformed them by a huge margin. Effectively, when the theme is macro, adopt a top-down approach and when the theme is micro, you adopt a bottom-up approach.

Growth versus value approach: 

This is a slightly more tricky game and in many cases it is hard to define. You get to hear this discussion on value versus growth quite often. This argument has more to do with P/E ratios. Normally, value stocks are quality stocks that are available at attractive P/E ratios in absolute terms. Some industry benchmarks are set and decisions are taken. For example, if IT is available at 12 times P/E or steel is available at 5 times P/E, then they are classified as value plays. Value stocks can also be understood in terms of their dividend yields. For example, stocks like NMDC are giving dividend yields of 9-10% currently, making them value buys.

Growth approach, on the other hand, focuses on the ability of the company to grow. Here P/E is not too relevant as long as the rapid growth can justify the same. No P/E benchmarks are considered here. For example, if a stock like Motherson Sumi can growth at 30% for the next 5 years then it can be purchased even at 35 times P/E, irrespective of the auto ancillary sector’s average P/E. Typically a value approach works more in case of large cap companies, while a growth approach works better in case of mid-cap companies. 

Hard versus soft factor approach:

These are normally not distinguishable from one another as fund manager use both these criteria to take a call on stocks. Hard factors are those that can be expressed in numbers. Sales, growth, profits, margins, inventory turnover, efficiency etc are hard factors that can be measured in tangible terms. They form an integral part of valuing and investing in a company.

Then we have the softer aspects! There is brand, reputation, entry barriers that cannot be valued or understood in terms of hard numbers. There is an element of discretion and judgement involved here. Why is this distinction important? There are certain sectors where one takes precedence over the other. For example, in industries like steel, capital goods, automobiles and banking, hard factors matter a lot. But in case of sectors like pharmaceuticals, FMCG and many emerging mid-cap companies, the intellectual property and the brand value can make a huge difference.

For a fund manager this poses a huge challenge. What metrics to use in which circumstances is the big challenge for the fund manager. It is only when fund managers are able to take an objective decision on these factors that you get mutual funds that turn out to be long term outperformers.

For all your mutual fund queries SMS ‘ASKMF‘ to 575758 and we will get back to you.

One response

  1. I would like to invest in SIP. I am confused that in which mutual funds I invest. Which mutual funds give more return. Pls guide me


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