How do mutual funds decide when to buy into beaten-down sectors like banking?

Fund managers rotate into underperforming sectors when they see a clear turnaround in growth, improving fundamentals, and highly attractive valuations.

Sector rotation is driven by evaluating two main things: a company's right to grow and its room to grow. The right to grow refers to its competitive edge or moat, while the room to grow refers to its total addressable market. When evaluating potential investments, we look at both qualitative and quantitative factors.

Qualitatively, a company must have a strong competitive edge, whether driven by superior technology, sheer scale, or network effects. For instance, in the internet and quick-commerce space, food delivery platforms benefit massively from network effects. As they scale up, their customer acquisition costs fall, which aids long-term profitability.

Quantitatively, these strengths must translate into a high and sustainable Return on Equity (ROE) and consistent cash flows. Looking at the banking and financial services space over the past six to nine months, we saw a perfect setup for a turnaround. The sector had seen muted performance for nearly 2yr, resulting in highly reasonable and attractive valuations.

At the same time, we started seeing initial signs of credit and loan growth picking up across the economy. The structural issues from the past have largely been resolved, leading to better earnings visibility and improving ROE for these banks. When these parameters shift positively, the portfolio is adjusted to capture the upside.

In a flexible setup like a multicap fund, this bullish stance can be executed across large, mid, and small-cap banks simultaneously. This allows the fund to capture the sector's recovery across the entire market spectrum.

Disclaimer: All information shared above are strictly for educational and informational purposes only. It should not be construed as financial or investment advice.