Is a low NAV Better! Or is an NFO good because its priced at Rs 10!
Our Answer – A resounding NO!
We thought this argument had died a long time ago but in some recent conversations with fairly experienced people , the issue raised its evil head again – which of course must be plaguing many many more Indians across the country.
The Genesis of this issue
Buying Cheap and Selling High is an oft repeated quote in stock markets – but when it gets equated to investing in mutual funds is where the trouble starts. Despite the heavy growth in mutual fund AUMs, sometimes even the smartest investors still equate the rationale used in stock markets to mutual funds and end up asking – “ The NAV of this scheme is lower than the other scheme so I would go with this one as it is cheaper!”
Basics First- What is a “Cheap” stock
A stock’s price is often the result of the demand and supply mechanics for the stock – and therefore sometimes the best stocks can fall into bad times and start appearing “cheap”. When one uses the word “cheap “ here , it often means it is relatively inexpensive today versus either its fundamental value or its all time highs or its book value and so on. Meaning the word cheap is used as a relative word – versus the stock’s real value – by itself the price doesn’t mean anything unless its compared with something.
Penny Stock investors on the other hand believe that smaller prices tend to multiply faster than larger priced stocks once momentum picks up (and irrespective of fundamentals) – which sometimes turns out to be true as many such investors find “affordability and greed” play out at times. And quite often not leading to financial ruin!
In both cases however, there is a hypothesis about future demand and supply and versus that the price is being considered “cheap”. That’s how stocks work.
The same rationale which is used to compare stock A versus stock B is often carried on to mutual funds. But mutual funds are a very different animal – which is often not understood.
First, lets understand what NAV means in the first place: NAV is calculated each day after the market closes — based on the market price of the portfolio of the Mutual Fund scheme.
The basics first -If you want to calculate NAV of a fund, the formula is:
NAV = (Value of Fund assets-Fund liabilities) / number of outstanding shares
This means that the NAV of fund A and NAV of fund B could be similar or different depending on the value of stocks they hold or on the number of outstanding units they have. The NAV is therefore just an accounting value and indicates nothing about the future performance of the fund – its just one value divided by another value.
To take the example further, Lets take a hypothetical example – Lets say Fund A and Fund B both have (only) Stock A (CMP Rs 100) and Stock B (CMP Rs 50) in different proportions (Lets say 70/30 and 30/70) and both have 10 outstanding shares/units. In this case, and using the above formula, the NAV of the first fund would be Rs 85/- while that of the second fund would be Rs 65/-.
Now ask yourself – What would you ask the advisor – Would you ask which stocks are likely to do better OR which fund manager has a better track record in picking portfolios or would you simply select the cheaper fund quoting at Rs 65/-!
If you asked the first two questions, you have already understood what we mean and you may stop reading this blog any further.
But if you selected the fund quoting at Rs 65/-, we have one more step for you to cover! Read on!
Lets say Stock A historically traded at Rs 200 (Current 100/-) and stock B at Rs 35 (Currently Rs 50/-) (and lets say both belong to same industry and have similar profile to make things simpler). Does it worry you that the fund which has more of the “Stock B” stock could do possibly worse off than the one with more of Stock A? The answer you give may not be relevant, to be truthful, but the fact is that if this question arose in your mind, it means you understand that it’s the stocks in the portfolio that will drive future performance of the fund and not the current NAV!
Congratulations! If you got it, stop reading this millionth attempt to explain the issue – but do hope you liked it!
Of course the above example is hypothetical because the fund manager may change his stocks at any point of time – therefore the question in the above case would not be “Stock A versus Stock B” but rather which of the two fund managers picks better- Fund A or Fund B. Again therefore the question is about fund management and portfolios and not which NAV was cheaper!
Still have a doubt?
Lets advance one year ahead – and lets say the markets took both the stocks to where they should belong historically – Stock A becomes Rs 200 (doubles from Rs 100) and stock B comes to Rs 35 (loses 30%)- and the fund manager forgot to manage the scheme and let the stock remain as they are. What do you think happened to the NAVs?
Well, Fund A’s NAV jumped to Rs 150.5 (from Rs 85) and Fund B jumped to Rs 85.5 (from Rs 65)! Meaning Fund A generated a return of 77% while fund B generated 30% – why? Because the stock composition of the portfolio was different! And not because cheaper NAV had anything to do with it!
Let’s say you invested Rs 10,000 in both schemes – the returns would have come at the same rate as above irrespective of the number of units you got. Fund A would become 17,700 and Fund B would become 13,000.
Cheap didn’t matter!
What about New Fund Offers (NFOs)
When a company comes out with an IPO , it is promising you future potential growth and must have priced a stock “cheaper” than perception or potential. And you buy it based on someone’s recommendation or your own analysis. And you make money! What you did was buy into a story that was yet to develop – and the price was not very high.
New Fund Offers are a different issue altogether. The fund issues decides to issue units at Rs 10/- which everyone subscribes to at the same price – and therefore get units basis the investment. It’s a simple accounting issue – nothing to do with potential of the fund. What happens into the future has nothing to do with price – unlike the stock above – it depends on market conditions, the fund managers abilities and his expenses etc.
Both are different animals!
The price at which one buys mutual fund units becomes irrelevant if you are looking for returns – it’s the fund manager’s track record that matters!
Lower NAV means nothing when it comes to deciding whether mutual fund being overvalued or undervalued.
A stock’s market price can be a bargain (or undervalued) if investors believe the company should be worth much more, and it can be expensive (or overvalued) if investors feel the company is not worth much. On the other hand, NAV is based on the current valuation of the fund’s underlying assets and has nothing to do with how much investors think the fund should be worth. Meaning, there is nothing called a “fair” price for a fund.
All mutual funds start with an NAV of Rs 10/- as a conventional accounting measure – it doesn’t mean they are cheaper than another scheme with an NAV of Rs 100 – the latter reached Rs 100 because it was launched years ago and the portfolio value has grown over time, that’s all.
In summary therefore, checking a fund’s NAV before investing is absolutely a futile and a baseless exercise, in our opinion.
Prabhudas Lilladher MF research teams regularly analyse mutual fund schemes and recommends schemes based on a wide number of parameters and would love to advise you on your portfolios. Please click here for our recommended schemes OR click here to understand more about Investactive MF, our end to end MF Research Product. Alternatively, do mail us at email@example.com if you wish to know more about mutual funds or our services.
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