Swimming against the tide
Look for firms that are being ignored currently but have the potential to be multi-baggers
Trend looks like a friend when markets are bullish. When the tide turns, those chasing ‘hot stocks’ exit their holdings mostly at a loss. But a contrarian investor, who went against the herd, would have his portfolio in green. Some of the most successful investors, like Warren Buffet, have delivered very strong results consistently through their contrarian style.
Contrarian investing refers to an approach where a person invests in a direction that is completely opposite to current market sentiment. It can be being fearful when others are greedy, that is, exiting when valuations get uncomfortable despite the investor community predicting the next high point of key benchmark indices - Sensex and Nifty. But when market is on a downward trend, a contrarian investor would start looking at a point to enter it.
Such calls are not taken just because it has to oppose the current trends. A good contrarian studies different economic and financial parameters to take a call on the market movement, sector, or a stock. Usually, contrarian investing is a play on valuations as the market is either overvalued or undervalued by its participants at any given time. Such investors also chose to opt out from participating in the extreme phases of market. Benjamin Graham, considered as father of value investing, has said: “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
A classic example of this is seen in the mid-cap index. Historically, whenever CNX Midcap index crossed the price-to-earning (P/E) ratio of 25, the index corrects (see table: Playing Valuations). A contrarian investor following this trend would study the valuations of the companies and enter when comfortable and exit from the midcap segment when the P/E reaches the 25mark. He may lose out on the small potential upside but this strategy will reduce the risk of potential downside. A contrarian strategy not only helps an investor to have a balanced portfolio but safeguards it against probable losses.
Another example in the recent market trend would have been someone who took a call on metal stocks. The CNX Metal Index towards the end of August was at 1,700 level. Many companies in the sector were at their 52-week low. In the last trading session the index closed at 1834.95, a gain of around eight per cent in less than two months.
When the domestic markets were correcting recently due to global concern on European and Chinese economy, a contrarian investor would have looked for an opportunity to invest rather than panic and book profit. An investor, who follows the momentum strategy, will look for short term investment opportunities. One of the crucial elements of contrarian calls is taking a long term call, studying correlation between markets and assets, and ignoring short term volatility.
In the current situation, where markets have started rising since the Reserve Bank of India’s policy announcement, there are sectors that can turn out to be contrarian bets. But they will need to look at the valuations thoroughly before making investments in the companies. Metals: Despite the recent rally, there are still attractive bets available in the sector. However, too many factors affect companies in this space. They are impacted by the country's economic performance as well as global demand. In the past few years, these companies are underperforming due to global overcapacity, subdued domestic demand, decreasing prices, rising input costs and delays in obtaining procedural clearances for mines. Commodity cycle, however, is unlikely to turnaround in the short run. Hence, one can look at investing into metals in a staggered manner. Companies that would be attractive buys are ones which have captive assets, strong visibility on earnings growth over the coming few years, and are not highly leveraged. Cement: The sector is directly linked to the economy’s performance. Businesses here could be poised for a turnaround in the coming quarters as the demand in the country picks up. Once the government spending increase and demand for housing is back, the sector could give good returns. Focus on companies that have capacity and will benefit from an uptick. Infrastructure: Many pure infra companies in construction space are highly leveraged. But selective bets can help investors gain rich rewards. The government has taken the first step toward infra by starting work on the stalled projects. PSBs: There are lot of concerns on the asset quality of public sector banks. But the government has launched mission 'Indradhanush' to revamp them. Among the reforms that finance ministry is planning to carry out include appointments, capitalisation, de-stressing, framework of accountability and governance reforms. These companies will benefit from falling interest rates. One can focus on companies with relatively better asset quality. Aviation: The sector is a big beneficiary of global events. It will benefit because of the lower crude price and the change in the consumer habit. In the growing economy like India, more and more consumers will prefer to travel by plane rather than train or road. The quality of the management is also good in the sector.
Taking contrarian calls not only required understanding of businesses and economy but also experience. Investors should not go overboard with the investment strategy. They could end up adding stocks that are value traps. In this a company may appear cheap because of a large price fall or valuations but is actually still expensive relative to intrinsic value. It can especially happen if there are certain fundamental triggers that have a negative impact on the outlook of the company. After all, the price of a stock will only rise if there will be demand for it. Contrarians need to therefore look for stocks that are currently ignored but would come back in vogue in the future. Contrarians also run the risk of investing too early in a down cycle and find that the stock prices fall significantly from the point that they invested. It is, therefore, important to look for certain leading indicators.