S Naren’s Contrarian Call: Defensive, but bullish on banking & insurance

Sankaran Naren - ED & CIO - ICICI Prudential Mutual Fund

The ICICI Prudential Value Discovery Fund (IPVDF) has turned 20. And its fund manager, Sankaran Naren, who's also the Executive Director and Chief Investment Officer at ICICI Prudential Mutual Fund, continues to track the markets like a hawk. Although Naren is a veteran value-strategy fund manager, he concedes that over the years the value-style  has undergone a change.

As of now, Naren is cautious as equity markets continue to surge. Hence, his scheme’s portfolio is defensively positioned, he says, with the exception of banks. Also, he and co-fund manager Dharmesh Kakkad have been picking up insurance stocks for some time now.

Apart from the ICICI Prudential Value Discovery Fund, Naren manages four other funds, most notably the ICICI Prudential Balanced Advantage Fund.

How has the concept of value investing evolved over the years?

When we started IPVDF in 2004, our approach was what was then called cigar-butt investing.  Which meant buying stocks with a low price-earnings (P/E), price-book (P/B) ratio and waiting for a bump. But as the fund’s size went up, we found that the model wasn’t quite working.

What works is a more quality-oriented model or a model where you identify contrarian opportunities, such as a stock that's fallen below its intrinsic value. Around 2007, the traditional cigar-butt model was found to be increasingly irrelevant. That is when we moved to buying good businesses at fair value, rather than average businesses at a cheap valuation. That became the new mantra for value investing.

How do you manage to maintain the core principles of value investing and adjust tactics depending on market dynamics?

Value investing involves buying stocks below their intrinsic value. Over the last 20 years, there have been periods when certain areas have become cheap relative to the rest of the market.

Currently, we  have a situation where all sectors, with the possible exception of financials, have done well. We believe that such an environment where almost everything is doing well, value investing suggests that long-term investors should resort to asset allocation.

On the other hand, if you take periods like 2007 when infrastructure did very well and the rest of the market was cheap, it was very easy for us to look at other sectors instead of infrastructure. Largecaps were very cheap relative to small and midcaps in 2017, and in 2020, metals, telecom, and public sector undertakings (PSUs; government-owned companies) were cheap relative to the market.

Over the scheme’s 20 year history, what has changed and what hasn't?

Initially, our focus was on low PE, PB ratios. However, much like Warren Buffett, we soon realised that this approach often led us to invest in sectors with poor long-term prospects — what we call the "gruesome" sectors of the economy.

Over time, we adjusted our approach, prioritising quality sectors that were underperforming temporarily and did not have deeper, structural issues. For instance, we began investing in telecom, metals, and power — industries that were struggling not due to flawed business models, but because of external, temporary challenges. This marked a major pivot in our investment strategy.

We also had to adjust our focus as the fund grew. Between 2004 and 2008, we were more of a small and midcap fund. However, with our assets under management (AUM) now crossing 50,000 crore, we've naturally gravitated towards largecaps. This shift has improved liquidity for both investors and fund managers.

While the underlying philosophy of value investing remains consistent, our strategy continues to evolve. For example, if the overseas investment cap increases, we may diversify globally when Indian markets seem overvalued, and return to Indian stocks when they offer better value. This kind of adaptability will be crucial as the fund grows further.

How do you often capitalise on market fear to find undervalued companies?

Market fear is a key element that needs to be navigated because a lot of the money comes from open-ended funds, and investors worry about the near-term instead of thinking long-term. We do get such opportunities periodically, and that has helped us in certain years, like 2020, to build an aggressive portfolio when the markets were very cheap. However, some of these strategies don't result in near-term benefits, and the returns are better over the long term.

When did ICICI Prudential Value Discovery Fund test your patience?

Clearly, 2007-2008 was very tough, because at the end of the day , in 2007, infrastructure outperformed everything else. And  in 2008, mid and smallcaps continued to underperform in line with the market, irrespective of how they had fared in 2007.

So I would say that the 2007-2008 phase was a big test for value discovery, and it required 2009 to actually prove that value investing is a good approach for the long term.

Do value fund managers need patience to wait for  opportunities and strike when the time is right? Did you do something like this in March 2020?

2020 was very easy, because the markets recovered quickly. But at various points in time, taking bets on sectors like telecom or metals, or even segments  like PSUs, tested the investors' patience because it took years to see the returns. So, value investing is indeed a test of patience and temperament, and that is one of the reasons why we believe long-term investors are the biggest beneficiaries of this approach, and those who choose to invest when the value strategy is doing badly are the people who derive the greatest benefit from it.

You look at macro factors closely. What's the biggest success you've had  because of that?

Between 2011 and about 2013/2015, we invested in information technology (IT) and pharmaceutical. We were big believers in these two sectors because we thought the Rupee was going to depreciate a lot. We benefitted from the move of the Rupee from Rs 45 to a US Dollar (in 2011) to Rs 65 (in 2015).

Around 2014-15, we saw that the banking sector was going through a massive NPA (non-performing asset) problem. Therefore, between then and 2018, we avoided public sector banks and non-banking finance companies. And we were never hit in that area.

Post Covid, we concluded that nothing was going to be seriously wrong with the world and we saw a buying opportunity. We bought metals, IT, and even PSUs.

Which sectors are you buying these days and how are you positioned?

We are defensively positioned, with the exception of banks where the valuation gives us a lot of comfort. But we have bought private-sector banks, not public-sector ones. We've also taken a big position in the insurance sector. We've bought stocks of most insurance companies.

Why insurance?

Because we felt that insurance has done very badly relative to the rest of the market. So around three to six months back, we built up a big position. Our intrinsic value-to-price model suggested that there is good scope in this sector.

The correction in share prices of insurance companies was mainly because a lot of regulations were introduced  that people thought would dent the sector’s growth. At a fundamental level, we see  no reason to worry and the price has corrected enough and more. So we seized the opportunity and bought insurance stocks.

You have minimal exposure to the infrastructure sector.

Most sectors are very costly right now. That is why we have even cut some holdings in the power sector, although we had a large exposure to this industry. We have cut holdings in telecom. Capital goods is also trading at a very high valuation.

What are the big mistakes that value fund managers make and how do you avoid them?

Be very careful of leveraged stocks.

Be careful of bad or weak company management.

We are in the middle of the biggest bull market, which is why mistakes don't really  show up right now. But they will in a bear market.

Such mistakes are applicable even to your other funds, isn’t it? For instance, no fund manager would invest in a company knowing that it comes with bad management.

When a value fund manager buys a value  stock, he is always more worried. He buys a stock knowing that there is some flaw in there. That’s why it's a value stock. The classic trap is that the fund manager tends to be more tolerant of a flaw in a value stock. When you’re picking a growth stock, you never tolerate flaws. So value-strategy managers have to be doubly careful.

If you have to manage Warren Buffet's portfolio, how differently would you do it?

I don't have to answer such complicated questions <laughs>.

Buffet manages a close-ended fund where his biggest advantage is that no one can take out money consistently from the fund. Hence, Buffet enjoys unbelievable amounts of flexibility, compared to Indian fund managers who manage open-ended funds where investors come and go all the time. I feel bad that in India, mutual funds are discouraged from launching close-ended funds.

I would love to have more close-ended funds, more close-ended money. When we know that investors are genuinely here for the long-run, it gives us a lot of room to pick up stocks and hold on to them till their true value emerges.