FundsIndia Views: The equity lessons in 2016

The close of 2016 seems to be echoing the start of 2016, with the stock markets on a downward slide. Sandwiched between these two declining phases was a period of joy ride, especially for mid-cap and small-cap segments of the market. Having contended with several bolts from the blue, the stock markets closed 2016 on a flat note. The stock market and the performance of equity funds in 2016 serve to reinforce the gospels of equity investing.

The large-cap mid-cap battle

Look at the table. There was a significant divergence in the returns of mid-cap and small-cap funds against the large-cap funds in the middle of the year. In the tremendous bounce back mid-cap funds charted from March 2016, the fact that mid-caps can fall just as steeply was forgotten. Top performers DSP BlackRock Microcap, Sundaram Select Midcap, Birla Sun Life Small & Midcap, Reliance Smallcap, all generated returns between 46-51 per cent.

The mid-and-small-cap run was increasingly at odds with the limited improvement in revenues and earnings. Revenue growth for mid-cap companies came in at 10.4 per cent for the September 2016 quarter, almost the same as the 11 per cent growth in the September 2015 quarter. Small-cap stocks saw flat revenue growth for the September quarter. While net profit growth was good at above 20 per cent for mid-cap stocks, earnings growth was similarly strong for large-cap stocks too. When the correction began in November, mid and small-cap stocks took a bigger blow.

For 2016, thus, this category delivered a 2.5 per cent return on an average. Just two months ago, in October, the category had been clocking one-year returns of 18.5 per cent. DSP BR Micro Cap, Mirae Asset Emerging Bluechip, Birla Sun Life Small & Midcap, Reliance Smallcap and Sundaram Select Midcap saw their returns close at 3-10 per cent for the year. Funds such as Sundaram S.M.I.L.E, Canara Robeco Emerging Equities, HSBC Midcap Equity ended the year either in losses or close to it.

The lesson: Being swayed by high one-year returns and chasing after ‘best’ funds is going to result in you putting all your money into overheated funds, and buying at highs. Comparing returns of two different fund categories is going to lead to wrong decisions.

Varying fund strategies

The market behaviour from 2013 to now resulted in a divergent fund manger view and strategy. One camp saw little to no promise in sectors such as capital goods, PSU banks, metals, power, energy, and infrastructure with economic growth sluggish, high debt levels, and overcapacity. They looked for quality and predictability in revenue and earnings which primarily saw them investing in consumer-facing stocks and software. The other camp saw stretched valuations in these sectors as a red signal and moved therefore to value picks in cyclical sectors.

2016 saw funds slightly cross over between camps. But the legacy of the previous years retained the difference in their portfolios. PSU and private banks shot up from March onwards. Energy stocks were the dark horses of 2016. Infrastructure stocks too did well. Funds that followed a value-oriented strategy, thus, saw their deliverance in 2016. Funds from the ICICI stable (such as Top 100, Focused Bluechip, Dynamic Plan) and HDFC stable (Top 200, Equity), for example, staged a remarkable turnaround.

Next, all three fund categories – large-cap, diversified, and mid-cap barely beat their benchmarks this year, a divergence from earlier years.

Several large-cap and diversified funds increased holding in pharmaceuticals, with the sector seeing valuations correct after a string of negative news. Though they reduced holding in the starkly underperforming software sector, they did not exit the sector. Both sectors are among the worst performers for the year. The gainers belonged to metals and mining. Stocks such as Vedanta, Hindalco, Hindustan Zinc, JSWL Steel, and NMDC clocked returns in excess of 30 per cent. Few funds had exposure here, given their relatively weaker fundamentals. Funds also had limited holding in the year’s other outperformers, oil & gas and power. For mid-cap funds, with much of quality rally done with in 2015, riskier stocks came up or valuations of quality ones were even more stretched. Staying away from such stocks (Tata Communications, Vakrangee, P&G Hygiene, Priamal Enterprises, for example) limited their returns.

The upshot of all this is that funds follow different strategies, based on their outlook, and this directly affects their performance. Where funds take a long-term view and base their stock and sector choices on that, there may well be periods of poor returns.

The lesson: Look at a fund’s returns in context of its strategy and history. Short-term bout of poor performance is not very worrisome if the strategy makes sense and the fund’s record in the long term is sound. In this, consistency in a fund’s ability to beat the benchmark and category average across years and market cycles is very important.

Meandering markets

The Sensex has returned nothing for 2016. It lost 5% in 2015. The BSE 500 returned 1% in 2016 and lost 1% in 2015. In both years, there were periods of strong gains and periods of declines that eventually left overall year returns going nowhere. 2015, in fact, saw the Sensex hit its all-time high. 2016 saw mid-cap and small-cap indices post high after high before crashing.

2014 gave no indication of what was in store for 2015, with optimism on economic turnaround and faith in the new government reforms riding high. Bolts from the blue in 2015 took the form of a slowdown in China. 2016 had even more of these – Brexit, the US election outcome, negative bond yields in some global markets, the raising of US interest rates, cancelling of high-value currency in India, the GST finally getting the green signal. In our own markets, continued suppressed revenue and earnings growth and a slower-than-expected economic revival weighed.

For investors driven by the stupendous 2014 returns, 2015 and 2016 served up a shock. Large-cap, diversified, and midcap funds saw their double-digit returns drop into single digits. These two years show that equity investing is not meant for the short term.

The lesson: Getting into equity with a short horizon is much too risky, as it can leave you with low returns or even losses.

Balanced funds deliver

Going all into equity would have ended in grief. Going all into mid-cap funds too, would not have given much pleasure at the year’s close. But while the going was tough for equity, it was quite the opposite for the debt market. Rate cuts and a yield rally helped the segment, especially dynamic bond funds and those that took credit calls, post good returns. With a 5.1 per cent return for 2016, balanced funds have delivered a better performance than pure equity funds as the debt portion compensated for the equity.

The lesson: Diversification is important. Spreading out investments across asset classes and fund categories would have helped contain losses and reduce portfolio volatility. Over the long-term, the better losses are contained, the higher the eventual return.

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.