The Better Choice
Irrespective of who creates larger shareholder wealth, following the investment ideas of institutional investors is one of the easiest methods of identifying quality stocks.
How to pick good quality stocks? Some advise looking at fundamental factors such as debt levels, operational performances and revenues while others believe in price-earnings (P/E) ratio, price-to-book value (P/BV) ratio, enterprise value and margins. But the irony of these valuation parameters is that nothing works on a standalone basis. Several combinations need to be considered, but small investors find them difficult to comprehend.
One of the easiest ways to identify good stocks is to look at the buying interest of institutional investors - both foreign portfolio investors (FPIs) and mutual funds (MFs). Institutional investors employ a specialised workforce that uses advanced techniques to identify fundamentally strong stocks. According to Ajay Bodke, Chief Executive and Chief Portfolio Manager at Prabhudas Lilladher, "Retail investors can look at stocks that form part of the institutional investors' portfolios as these stocks would have passed through stringent filters."
So, what kind of filters do institutional investors employ to select stocks?
"They tend to look at qualitative factors before delving deep into quantitative factors such as financials. Qualitative factors include corporate governance standards and the promoters' approach towards minority shareholders over a period of time. Such factors play a major role in deciding whether the investment idea should be pursued further," says Bodke. When a stock passes the qualitative criteria, its valuation ratios such as P/E, P/BV and enterprise value to EBITDA (earnings before interest, tax, depreciation, and amortisation) are compared with its historical averages as well as with its competitors to determine its fair value.
Gautam Duggad, Head of Research, Institutional Equities, at Motilal Oswal Financial Services, says, "Different investors use different yardsticks. Earnings growth opportunity, quality of business, quality of management, opportunity size of the category in which the company is present and valuations at which the company is available are some of the common factors used to select investment ideas."
Following institutional investors seems to be a good idea but which of the two - FPIs or MFs - would be better regarding shareholder wealth creation? We conducted a small study to determine whose investment strategies/stock selection techniques are superior. For this purpose, we considered listed companies with a market cap greater than `500 crore and formed two groups. Group I includes companies where MFs consistently reduced their stake and FPIs consistently increased their stake for a span of five quarters, from April 2016 to June 2017. Group II contains companies where MFs have consistently increased their stake and FPIs have consistently decreased their stake during the same time frame.
Twelve companies made it to Group I while 16 companies made it to Group II (see tables Group I and Group II). The point-to-point (absolute) stock price returns of these companies are considered between June 30, 2016, and October 18, 2017. Group I that contains companies where MFs were exiting but FPIs were entering, delivered average returns of 53 per cent. On the other hand, Group II that contains companies where MFs were entering but FPIs were exiting delivered average returns of 42 per cent (see table Rise and Fall where we take a close look at the top five companies that had seen maximum disruption when it came to topping up or bottoming out investments by MFs and FPIs). During the same period, the BSE Sensex delivered 20.6 per cent returns. Both groups outperformed the market, thus representing the supremacy of institutional investors. However, FPIs emerged as better wealth creators compared to MFs.
It means following the investment ideas of FPIs may prove to be more beneficial than following the MFs. Experts, however, believe that one should be cautious in making such interpretations. According to Duggad, the time frame chosen is just five quarters and drawing such broad conclusions will be risky unless the same is studied for a longer span.
Bodke, however, backs domestic institutional investors irrespective of the study results. "Many FPIs, which do not have India-dedicated funds but whose investments in India are part of an emerging market or a global fund, tend to take a top-down approach and would typically invest in large liquid names only. They will refrain from a bottom-up approach to investments where one tends to identify small, undiscovered and relatively not-so-liquid stocks, which invariably tend to be multibaggers. Understandably, those portfolios outperform over medium to long term. Domestic financial institutions adopt such an approach, and hence, they are favoured by many investors."
Although experts are not unanimous that FPIs are better wealth creators, numbers seem to favour the former. Whether investors trust the superiority of FPIs over MFs or not, one can make good money by following the stocks bought by institutional investors.