Typically, fund managers pick stocks and sectors that are in favour, to get the returns kicker. But schemes that follow contrarian investing are mostly like value funds. They pick sectors and companies that are out of favour now, but have the potential to go up in future. The aim? Get the first-mover edge when the cycle turns favourable.
Dinesh Balachandran, fund manager of SBI Contra Fund, explains to Vatsala Kamat how he identifies stocks and sectors that are out of favour.
How do you identify stocks and sectors that are out of favour in SBI Contra Fund?
Companies can be out of favour because of abysmal earnings, beaten-down stock prices and weak growth outlook for the sector. Our challenge is to identify them and invest if we see merit in them.
For instance, the healthcare sector till 2015 was booming with many multi-baggers. But from then till early 2020, the sector did not do well because of competition and a drop in earnings because of price erosion in the US, among other factors. Investors lost patience and sold pharmaceutical stocks. But our scheme invested in them because we saw value in them. And we won.
Take the power sector. It was the darling of markets between the years of 2000 and 2010, but suffered a huge de-rating for nearly a decade now due to changes in macroeconomic factors. Again, over the past year, these stocks have done well.
What are the challenges in identifying such bets and how long does it take for valuations to catch up?
It’s challenging. We need to make sure that the company doesn’t suffer from any corporate governance issues. Then again, the stock might fall further even after we buy. Typically, markets dismiss a sector towards the end of the earnings cycle. Contrarian investing needs a lot of patience and conviction.
In a cyclical sector, earnings turnaround could take time. But then, there could be triggers that fuel earnings growth or investor sentiment as seen presently in the healthcare sector, after the pandemic.
However, it is not enough to identify value ideas that may be cheap. One must identify the trigger points to unlock value: is it imminent or is it a long haul? The opportunity cost can be significant. In cyclicals, it is important to figure out the macroeconomic factors that impacted the sector in earlier cycles.
Your top holdings show significant exposure to large banks. Given the run up in stock prices, how do these qualify as contrarian strategies?
Here, we focused on banks that have higher exposure to corporate lending. This sector has been under pressure and non-performing assets (NPA) of banks had gone up. We saw a lot of pessimism. But we also feel that the corporate NPA cycle will become better now. I expect the benefit to last for several years.
How do you decide when to sell your holdings?
That is tricky in a contrarian fund. Either we hold on to a stock till we remain convinced that we have realised its full potential. Or, we sell it and replace with another theme or sector that is available cheap and whose future earnings capacity shows great potential. The biggest mistake a fund manager can make is to sell too early.
Liquidity is another challenge: often seen in small and mid-cap stocks. Some of these stocks have the potential to create alpha, so it’s hard to sell them on time due to illiquidity.
The Sensex is at its highest ever closing level. Are there contrarian stocks or sectors in such rising markets?
Yes. Government-owned companies or PSUs (public-sector units) are contrarian opportunities. These companies are slowly beginning to show better capital allocation, improved efficiency and higher dividend payouts. Valuations have been low for years.
Another contrarian opportunity is the energy sector where due to both ESG and economic issues, companies are unlikely to set up new refining capacities or spend on new developmental blocks in oil. This opens up room for existing players to improve their profitability. In real estate, housing affordability has improved due to price/time correction in home prices and low interest rates. Excess inventory is being absorbed, setting a base for an upcycle. We are trying to increase allocation to the residential retail segment.