Good time to buy quality index funds

The Indian stock market has seen a correction in the past month on weak earnings and a barrage of foreign investor selling. While the Nifty50 or Sensex30 have corrected only 6-7 per cent, there are several stocks in the broader market that have declined over 20-30 per cent.

Long-term investors looking to buy equities now, can take two approaches. They could look for stocks trading at low valuations based on price-earnings, price-book value, dividend yield and so on. Or they could pick up high-quality companies that have turned cheaper because of the correction. These are the value and quality approaches to investing respectively.

The value style has been a significant outperformer since Covid. However, the quality style has been a laggard. As of November 5 2024, the Nifty200 Quality 30 index has managed a five-year CAGR of just 16 per cent. This significantly trailed the Nifty momentum index return of 26 per cent and the value index return of 29 per cent, and also the Nifty200 return of 17 per cent. The underperformance has been particularly sharp in the last three years.

What’s quality?

This makes it a good time to buy equity funds managed in the quality style. The quality style of investing focuses on choosing the best companies to invest in, based on their superiority in shareholder return metrics. Quality investors like to buy stocks with the highest Return on Equity (ROE), Return on capital employed (ROCE), operating profit margins (OPM) and secular earnings growth. Typically, these filters throw up companies in market leading position with a competitive moat. Quality style investors do not mind paying high valuations for stocks that meet their quality parameters and have high shareholder return metrics.

Performance

Though the quality style of investing has underperformed in the last five years, selecting stocks based on fundamental metrics such as return on equity, capital employed or earnings stability seldom goes wrong in the long run.

Rolling return data for the 2005 to 2019 period show that the Nifty200 Quality30 index beat the Nifty200 almost 100 per cent of the times, for investors holding for 5 plus years. The year-wise returns show that quality indices are good defensive bets because they fall much less than the market in sharp corrections. In 2008, the Nifty200 Quality 30 fell 51 per cent against the Nifty 200’s 57 per cent fall. In 2011, it fell 12 per cent against the Nifty 200’s 27 per cent decline. In the Covid crash of March-April 2020, the quality index fell 22 per cent against the 28 per cent crash in the Nifty200.

The data also show quality stocks enthusiastically participating in the big bull markets that came after the meltdowns. The Nifty200 Quality30 outdid the Nifty200 in 2005, 2009, 2010, 2013, 2014 and 2015 – all years where markets notched up big gains.

The passive menu

So if you are sold on quality-style index funds, what are the choices available on the menu?

While active fund managers may use qualitative assessments on the durability of a company’s moat, governance etc. in addition to ROE, ROCE and OPMs, passive funds following the quality factor use only quantitative metrics.

Currently, a majority of passive funds on the quality theme use three NSE indices as their underlying – the Nifty200 Quality30, Nifty100 Quality30 or the NiftyMidcap150 Quality50. The BSE also offers a BSE Quality Index, which has one index fund. Your choice of fund should depend on which underlying index is better.

Which index?

At this juncture, the NSE indices appear a better bet. The NSE quality indices apply three main filters to choose their constituents from the parent index of Nifty100, Nifty200 or Nifty Midcap 150. They filter stocks for low debt/equity, high return on equity and low variability of earnings growth in the last five years. Filtering for low variability of earnings weeds out companies with cyclical or inconsistently growing earnings. Stocks are finally selected based on a blended score of these three factors with equal weights assigned to each.

The BSE Quality Index uses ROE, leverage and accruals as inputs to arrive at the quality score, which is used to select stocks. But it doesn’t filter out cyclical or commodity companies with volatile earnings. Therefore, the index features significant weights in these companies which the NSE indices manage to avoid.

Final choice

This analysis leaves you with three choices. Nifty200 Quality30 Index funds, Nifty100 Quality30 Index funds and Nifty Midcap150 Quality50 index funds. Analysing their valuations, sector weights and portfolios, the Nifty200 Quality30 has very concentrated weights in IT and FMCG stocks with a 30 per cent and 28 per cent weight in these two sectors respectively. It would be better to pick quality tocks from a more diverse range of stocks. The Nifty100 Quality30 index is slightly less concentrated with FMCGs (28.9 per cent), IT (24 per cent), Auto (13.8 per cent), Capital goods (7.9 per cent) as top sectors. It is available at a portfolio of 32 times and dividend yield of 1.9 per cent. This can be a good bet for conservative investors.

However, investors willing to take slightly higher risk should consider Nifty Midcap150 Quality 50 index funds, which have a far more diverse and interesting portfolio (See table). While the Nifty100 Quality30 index is made up of mature earnings compounders and dividend payers, the Midcap150 Quality50 features compounders with a long growth runway. DSP Mutual Fund and UTI Mutual Fund offer funds based on this index.