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Suresh Krishnamurthy

The diametrically opposite philosophies of two equity schemes that have hit the market may just trigger a debate on which set of stocks are better — high PE or low PE. The odds seem to be stacked in favour of low PE stocks although the risks involved also are higher.

AFTER a spectacular rally in 2003 and an unexpected reversal since January 2004, the market now appears to be taking a breather. It is in this kind of a market that the initial public offers of two schemes, which subscribe to diametrically different investment philosophies, are hitting the market.

The schemes in question are Sundaram India Leadership Fund and Tata Equity P/E Fund. Over a period of five years or more, the Leadership Fund may end up with a portfolio that offers stable but low returns.

On the other hand, the PE ratio fund may offer higher, but risky, returns. The two offers require the investor to put his thinking cap on. That would also be an opportunity for investors to revisit the motivations and philosophy that drive their investment plans.

Diametrically different: The Leadership Fund professes to invest in a diversified portfolio of leadership stocks. These are expected to be the top two or three companies in each sector. Though there are a number of stocks of leaders that have low PE (such as Exide, Essel Packaging, ONGC, IOC, Balaji Telefilms, GE Shipping and Tata Chemicals), the fund would, by and large, have to invest in high PE stocks such as Ranbaxy, TCS, Bharti Tele-Ventures, Hindustan Lever and HDFC.

In addition, the proportion of `growth' stocks in the portfolio may also tend to be higher. Growth here refers to companies whose earnings are expected to grow at a higher rate than the average rate for the industry. In essence, the PE ratio of this portfolio is likely to be higher than that of the index.

In contrast, the PE ratio fund consciously chooses `value' stocks. Value here refers to stocks whose price is below their intrinsic value. The earnings of these companies, in general, are unlikely to exceed the average for the industry. The exposure of the fund to mid-cap or small-cap stocks, too, is likely to be high as large-cap stocks tend to be high PE stocks. At times, the concentration of the portfolio to any sector or theme may be high.

Expected performance: Between December 1996, when the Sensex touched a low of about 2,700 and February 2000, when it scaled the levels of 6,000, the performance of high PE or leader stocks was nothing short of spectacular. Low PE stocks or value stocks trailed the growth stocks by a long margin.

In contrast, the performance of low PE stocks in the bull-run between October 2001 and January 2004 was far superior to that of high PE leader stocks.

Which segment would do well, going forward, is largely a question of expected economic growth. If economic growth is likely to be robust, low PE stocks might tend to outperform. A debate has been raging in the US for a long time on the merits of investing in low PE stocks.

The consensus appears to be that low PE stocks tend to fetch better returns although the higher returns may be commensurate with the higher risks involved. This means that on a risk-adjusted basis, the returns of high PE and low PE stocks may be more or less equal.

Searching questions: So, which segment would you choose? A portfolio of high PE stocks may be the vehicle for an older investor who cannot stand high risks.

A portfolio of low PE ratio stocks may, on the other hand, suit a young investor willing to chase risks. Investors who fall between these two categories may have to go in for an allocation between the two segments that would suit their risk profile.

A predominant proportion of Indian diversified equity mutual funds, barring schemes such as Templeton India Growth, that are benchmarked to Nifty or Sensex, tends to be high PE portfolios. On the other hand, mutual funds which are benchmarked to BSE 200 or S&P CNX 500 or theme-based funds focussing on the Indian economy would tend to be low PE portfolios.

As regards these two funds, we can afford to wait for their first-year performance before deciding on including them in the portfolio.

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