How fund houses adapted to market valuation change

The P/B ratio is obtained by dividing the current price of the share by its book value.
The P/B ratio is obtained by dividing the current price of the share by its book value.

Summary

  • The ‘correction’ happened due to a change in how the P/B ratio was calculated by NSE.

Are the markets cheaper now? A popular market gauge used by analysts and investors suddenly showed that Indian markets have been trading at attractive valuations since September-end. Price-to-book (P/B) ratio of the benchmark Nifty 50 index, a metric used by many to judge the relative attractiveness of the markets, dropped to 3.45 on 29 September from 4.31 the previous day. The lower the ratio, the better it is—implying that the value of stocks is comparatively cheaper and ripe for investments. It is now hovering around at 3.76.

But wait before you click the buy button. This correction happened due to a technical reason. However, the underlying fundamental and macroeconomics remains the same. The sudden correction happened due to a change in how the P/B ratio was calculated by the National Stock Exchange (NSE). The exchange cum index provider decided to replace the denominator with consolidated book value replacing the earlier method of using stand-alone book value.

The P/B ratio is obtained by dividing the current price of the share by its book value. Earlier, companies weren’t required to file consolidated earnings in their quarterly financial statements and, as a result, stand-alone book value was used to derive the ratio. But, over time, since the market regulator sought quarterly consolidated statements, NSE also changed its price-to-book (P/B) calculation methodology to incorporate this change.

To be sure, another popular valuation ratio, price-to-earnings (P/E), underwent a similar change in 2021. The Nifty 50 P/E ratio opened 18% cheaper on the day the change took place. This happened as the majority of the large companies have better earnings on a consolidated basis and, hence, the denominator was larger to pull the ratio lower. Even in this case, the lower the ratio, the better it is for investors.

One limitation of these changes, however, was its abrupt nature. All valuation metrics should be comparable with the past to be of any use. In this case, NSE did not go back and change the historical data. Hence, running investment models based on this metric might not be the best idea, say financial experts. Also, reporting of consolidated statements was mandated recently and some companies may have only reported stand-alone statements in their past quarterly statements which makes comparison over time-frames a tricky affair.

Against this backdrop, how are balanced advantage funds (BAFs) that require constant rejig of their equity and debt allocation coping with the recent change? BAF fund managers typically adjust their equity allocation according to prevailing market valuations. They use metrics like P/B, P/E, and dividend yield to judge the relative attractiveness of the markets.

 

(Graphic: Mint)
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(Graphic: Mint)

Motilal Oswal AMC

Motilal Oswal has a proprietary index called the Motilal Oswal Value Index (MOVI) to decide how to allocate between equity and debt. The model takes into account three factors: P/B,

P/E, and dividend yield. Each factor has an equal weightage.

Santosh Singh, fund manager of this BAF, said they changed the P/B and

P/E ratio calculation in line with the changes at NSE and incorporated it in the model. He said that it didn’t affect his model as the change was not significant enough for the model to suggest a different allocation.

“There is broad change within which I have to rebalance," said Singh. “We simulate every 6 months and we didn’t feel the need to rework as the change was not much"

Besides, if the model throws up a significant change and suggests a different allocation strategy, the fund managers can use their discretion to override it and rework the model.

When it comes to analysing individual companies, the fund managers decide for each company whether to use stand-alone or consolidated statements. For instance, Singh said Bajaj Finserv is a holding company and has little to show in its stand-alone book but since it owns Bajaj Finance, which is a core lending company, they look at the consolidated numbers.

Further, Singh said that MOVI is currently showing a 60-70% equity allocation range, with the MOVI index standing at 99.8. At 100, it will indicate that the equity allocation be lowered to 50 -60%. “It can anytime go to 100 and suggest 50-60. Currently, the BAF is sitting at 60.2% equity allocation," he added.

DSP Mutual Fund

DSP’s Dynamic Asset Allocation Fund allocates money into debt and equity at any point. To decide how much to allocate in each asset class, it uses a combination of fundamental and technical factors.

For fundamental analysis, it uses P/B and P/E ratio whereas for technical factors, the fund looks at the momentum and trend of the markets. The interplay between these two factors decides the final allocation toward equity and debt

Anil Ghelani, head of products at DSP Mutual fund, said that when the

P/E ratio change happened in 2021, it did not move the needle much. That’s because the earnings of some companies went up when changed from stand-alone to consolidated while for others they went down. For instance, Tata Steel was making profits on a stand-alone basis but loss-making after taking into account its global operations. Sun Pharma, though is loss-making on a stand-alone basis but profitable at the consolidated level.

According to DSP’s research on the Nifty 50 PE methodology change, 39 companies started showing better earnings and hence had a positive impact on the P/E ratio, while nine companies showed lesser earnings and had a negative impact. The remaining two companies remained the same.

When NSE changed the P/E calculations from stand-alone to consolidated, DSP followed suit. However, in the case of P/B, it is still using standalone figures. It is studying the P/B ratio closely and yet to decide on the future course of action. “I don’t think it created much disruption in the numbers. P/E wasn’t a big change and for P/B we’re still using stand-alone," said Ghelani.

Tata Mutual Fund

Rahul Singh, chief investment officer of Tata Mutual Fund, said they have always looked at the P/E ratio from a consolidated level as obtained from the Bloomberg terminal. So, the change by NSE hasn’t affected their research, he claimed. Singh added that he looks at the average of trailing and forward earnings (Bloomberg consensus) and combines it with other technical factors like volatility and momentum to optimize equity and debt allocation. They don’t use P/B in their analysis.

When asked about some companies not reporting consolidated figures in their quarterly filings, Singh said that when it comes to the Nifty 50 companies, most of them had started providing consolidated numbers for quite some years. Singh said while it was not compulsory for the larger companies to give consolidated numbers every quarter, most of them still did it out of good governance practices.

ICICI Prudential AMC

ICICI Prudential runs a popular proprietary model called the Equity Valuation Index to decide how much to invest in equities and debt at any point. They incorporate factors like P/E, P/B, G-sec yields (into P/E), market cap to gross domestic product, or other factors deemed fit by the asset management company from time to time.

In an email reply, ICICI Prudential said it was always using consolidated data using its calculations and, hence, the change by NSE hasn’t affected its research.

 

(Graphic: Mint)
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(Graphic: Mint)

Conclusion

Investors should not take any action based on the current attractiveness of the P/B valuation metric as it was simply due to a change in its methodology. The underlying businesses haven’t changed.

On the other hand, the lesson that investors and fund managers can take from this episode is to incorporate multiple sources and ways of calculating valuation metrics so that when such changes happen in the future, they are not caught off guard. Even the big fund managers have different ways of solving the same problem.

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