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Find out how this ratio can help you take an informed decision while investing in mutual funds.
Investors tend to attach much importance to the price-to-earnings (PE) ratio and market capitalisation of a stock while buying. When used in conjunc tion with other metrics, these numbers can help in picking the right stock at the right time.
But can they also help select the right mutual funds? You may find it difficult to ascertain the investing style and preferences of the fund manager only by looking at the fund portfolio. This is where the fund’s PE ratio and average market capitalisation become good reference points. You can make more informed decision using these numbers.
In mutual funds, the PE multiple of a scheme is arrived at by using a weighted average of underlying stocks. In other words, it is the average of the PE of all the stocks that make up the fund’s portfolio, in proportion to their allocation within the portfolio. A high portfolio PE would indicate that the scheme mostly holds stocks that are quoting a valuation premium. This indicates a preference for growth oriented businesses. In a growth based approach, the fund manager does not shy away from paying a high price for stocks that are exhibiting healthy growth in profitability. On the contrary, if the PE of the mutual fund is on the lower side, it signifies a value-conscious approach. Here, the fund manager is more comfortable looking for stocks that are currently out of favour or where the stock price has been beaten down disproportionately to the fundamentals of the company. Growth oriented funds tend to exhibit strong returns within a short span of time but are more volatile. Value conscious funds typically yield great results over a longer period of time and come with lesser volatility in returns.
But the PE ratio is not of much use if used in isolation. Experts suggest using it in conjunction with the average market capitalisation to truly gauge the investing style of the fund. Both metrics should be evaluated within the broader context of its strategy. The valuation metrics in a mutual fund should not be used as an indicator for timing entry or exit, but for relative comparison. Check where the fund’s PE stands in comparison to its peers. Typically, schemes in large-cap category will carry a higher PE multiple compared to mid-cap and small-cap funds.
One should compare within the category to ascertain how the fund manager is positioning the portfolio as also how much risk he is taking on to deliver returns. Bala explains, If a mid-cap fund is carrying a lower market capitalisation than its peers, it suggests the fund manager has dug deeper into mid-and-small cap universe of stocks and is indicative of higher level of aggression. Similarly, a large-cap fund with a much higher average market capitalisation relative to peers implies the fund is more of a pure-play large-cap fund.
Take for instance the Motilal Oswal MOSt Focused 25 Fund, which is a large-cap offering. This top performing fund currently has an unusually high portfolio PE of nearly 25 compared to the category average of 19.
This clearly suggests an emphasis on selecting high growth businesses.
However, the fund’s average market capitalisation stands at nearly half the category average of `1.03 lakh crore. This shows the fund has chosen more nascent large-cap stocks rather than pure-play large-caps. A completely different approach is visible in Franklin India Bluechip, another solid large-cap offering. This fund carries a much lower PE ratio of 18.3 but the portfolio’s average market capitalisation stands at `1 lakh crore. This suggests the fund follows its large-cap mandate to the hilt and refrains from paying a high premium for growth. Similarly, a higher average market capitalisation within the mid-cap funds category would suggest the fund manager’s preference for nascent large-caps rather than pure mid-caps, while a lower valuation would imply a value-driven strategy. The Franklin India Prima Fund, for instance, has a market capitalisation closer to its category average but a lower PE, suggesting a valuation conscious approach. The average market capitalisation is useful in finding out if a fund is following its mandate. We have examples of funds whose mandate is to select stocks from the mid-cap space. However, an analysis of the average market capitalization shows more than 50% of the portfolio is concentrated in large-cap stocks. Such violations of the mandate defeat the purpose of investing in mid-cap funds, which is to create alpha.
These metrics can also be used for delving into funds belonging to the disparate multicap and ELSS categories. Given their multiple flavours, investors may struggle to make an informed choice based only on the return profile of the funds. A closer look at the PE ratio and market capitalisation reveal how the funds are placed in terms of investing preferences. Take for instance the top two performing funds in the ELSS category. With a PE of 29.3 and average market capitalisation of `47,444 crore, Axis Long Term Equity is clearly into growth-oriented businesses. Reliance Tax Saver on the other hand has a PE of 22 and market capitalisation of `18,771 crore, indicating preference for mid-sized businesses and a blend of value and growth approach. Investors should pick funds suiting their risk profile and needs, after filtering based on long-term return profile.