A time for contrarian investing

As the markets flirted with their low levels during the course of this year the one thing that was missing was a feeling of complete capitulation and total apathy and panic setting into the markets. Although I had expected the lows of around 15500 for the Sensex and 4700 for the Nifty to hold and they have held till date none of these events earlier during the year saw a sharp unrestrained fall in mid cap stocks and also in a large number of infrastructure stocks which most investors had been holding on with the hope of a bounce back. This phenomenon has happened during the last few days and I have got a feeling in the market which is similar to the period of January/February 2009 before the markets formed a durable bottom and set the tone for the next up move. 

I believe that the markets are now ripe for contrarians investing as a vast majority of stocks are underperforming and it is only the high priced defensives that are outperforming. An analysis of the BSE 500 since the beginning of the year shows that out of 500 stocks only 90 are up and the rest of them are down for the year. —

So what is the basic tenet of Contra investing-?

Uncertainties emerge in global events, economic growth, government policy etc. All such events converging today, creating huge opportunity for generating future returns. Thus current environment is apt for contrarian investment

The reasons why a Contra strategy is apt at the current point of time are 

—Most funds/investors are betting on the safest stocks. Top holdings of mutual funds are all among the top 10 market capitalized companies in India and constitute over 30% of total equity holdings .When these stock don’t move, several MFs don’t perform in the short run and this kind of Risk Aversion prevents more creative stock selection.

—Majority of stocks have not performed in the last 12 months, although market is 20% down from the peak, several stocks are languishing much below their historic high

—Economic growth is bottoming out and fundamentals can only improve

—Significant fear clouds judgment and impedes value unlocking and Lot of high potential stocks cheaply available and a large number of well Several well established stocks have seen sharp P/E reduction showing loss of investors belief

Long term fundamentals of most of the stocks remain robust while there are short term challenges

All this has led to high under ownership in a vast majority of stocks. As a contrarian investor sudden drop in investor interest poses an entry opportunity.

—        As fundamentals change, the extent of under-ownership determines the speed of appreciation

—        A rightly timed investment into a under-owned stock can result in quick gains

—        Exit is easier when the herd comes in

The contrarian strategy is also applicable in investing over market capitalizations where mid caps/large cap premium and discount varies over periods of time depending on market sentiments. This switch between market capitalizations is also a contra strategy which is largely favoring mid caps at his stage.

The key is that contra investing is not value investing. The key is that when growth investing is contra one has to be a growth investor, when value is contra one has to go growth.

The contrarian investment theme is often confused with the fundamental or value investing. But it is a fallacy….It involves far more complex thought process. It is a way of thinking which is difficult to emulate.

•        Contra investing also requires incubating stocks for some time before they find favor with the rest of the market. Proactively identify new investment themes and build up strong positions before a majority of investors

•        It is also important to Monitor stock/sector ownership and relate it to the fundamentals of the sector. Get out of over owned stocks and get into under owned ones. Avoids momentum stocks and over owned sectors, thus improves risk profile

At this stage my key contra bets will be well established mid sized corporates which strong brand franchises or business franchise which might have some short term concerns that are leading to a severe mispricing of the long term potential. If one takes stocks with a market capitalization of at least Rs 1000 crores where stocks are down at least 60% from their peak values or the valuation discount from the peak valuations are at least 50% a portfolio of at least 20 high quality stocks can be easily built which on a buy and hold strategy can yield at least 100% over a two year holding period.

However while evaluating such companies it is also important to evaluate companies in a manner where there should not be a value trap as some companies specially in the infrastructure sector have destroyed their balance sheets via aggressive bidding and high Debt: Equity levels to such an extent that there is very little tangible equity value left in these companies, although the stocks might be cheap on a Price to Book basis.  Again to reiterate the value trap is the biggest folly in contrarian investing.

However on the flip side it is also true that post evaluation if one comes to the conclusion that as interest rates ease off and cash flows improve the debt burden can be reduced then one of the biggest equity value creations do happen via the shift of the total enterprise value from debt to equity while the overall enterprise value might not change. For example, let’s say there is a company with Debt+Equity of Rs 10000 Crores out of which, on today’s day Debt is Rs 8000 Cr and Equity is Rs 2000 Cr. Over the next couple of years it can happen that the overall company value does not change but Debt comes down to Rs 6000 Cr and Equity value goes upto Rs 4000 Crores. As such equity returns can be 100%.

In January 2008 India's market capitalization peaked at Rs 75 Lakh Crores and Market cap to GDP was at 160% & in March 2009 the Market Capitalization bottomed out at Rs 30 Lakh Crores.

Current Market capitalization stands at Rs 70 Lakh Crores and Market cap to GDP is at 77% on 2011-12 GDP & 65% on 2012-13.

—        Eventually as the bull market matures over the next 3-4 years, the Market cap to GDP should approach the earlier peaks.

—        India’s GDP in the year 2014-15 should be at Rs 135 Lakh crores.

—        Assuming a mature and peaking bull market at that stage the market capitalization could be at around Rs 200-220 Lakh crores.

—        This implies a tripling of Market Capitalization from the current levels over the next 4 years.

—        Per annum returns could be at an average of 25% plus.

—        The current bearishness and apathy towards equity could be one of the best entry points for the Indian markets

Since it’s already become a big note on Contrarian Investing I will write more on this subject later. However the value in the market is tremendous today and selective buys at these levels will generate huge returns over the next bull cycle.