Should you invest in contra funds?

Fund houses are launching contra funds as several sectors face disruption amid global uncertainty. Bandhan Asset Management Company, ICICI Prudential AMC and Motilal Oswal AMC have recently launched contra funds. WhiteOak Capital AMC, a newer fund house, has also filed for one with Sebi.

Here is how contra funds work and what investors should consider before investing.

What is contrarian investing?

A contra fund buys stocks or sectors that the market has turned away from. These may have underperformed the broader market, trade below their historical valuations or simply be overlooked by investors. The fund bets that the market is too pessimistic and that the stock will be re-rated when the business recovers or sentiment improves.

This approach overlaps with value investing, but the two are not the same. “All value is contrarian. Not all contrarian investing is value,” said Sirshendu Basu, head of product management and strategy at Bandhan AMC.

Value investing starts with the numbers. It examines earnings, book value and cash flows to identify businesses trading below a reasonable estimate of their worth. Contra investing starts with a potential trigger, such as a cyclical downturn, regulatory overhang or technology scare. The premise is that the market has misjudged what happens next.

S. Naren, executive director and chief investment officer at ICICI Prudential AMC, explained the distinction with an example. A value fund cannot buy a quick-commerce company simply because its stock has underperformed, as it is a growth business whose valuation does not price in low expectations. A contra fund can invest in it if there is a genuine opportunity.

“Contrarian investing can include value, growth or quality stocks at different points in time,” he said. For instance, quality stocks have underperformed for six years. In 2020, they would not have been considered as a contrarian play.

Spotting turnarounds

The two styles also carry different risks.

A value fund faces the risk of a value trap, where a stock appears undervalued but is actually cheap because its business fundamentals are deteriorating permanently.

“A contra fund faces the risk of a contrarian thesis failing which is investing against prevailing market sentiment on the expectation that the market will eventually recognise an opportunity. However, sometimes the market consensus is right, and the anticipated recovery or re-rating never materializes,” said Ravi Kumar TV, co-founder of Gaining Ground Investment Services.

“Contra investing carries significant timing risk. Even when the investment thesis is eventually proven correct, the market may take time to recognize it. This can result in prolonged underperformance,” he added.

Fund managers also approach the contra mandate differently. Kotak Mahindra AMC applies two filters. The first is underperformance against the index, a valuation below the stock’s long-term average or a discount to peers. The second is evidence of recovery.

“There has to be a concrete sign of a turnaround in the fundamentals of the company,” said Shibani Kurian, head of equity research and senior fund manager at Kotak Mahindra AMC.

Kurian said the portfolio’s trailing 12-month price-to-earnings (P/E) ratio is broadly in line with its benchmark, the Nifty 500. However, its expected two-year earnings growth and return on equity (ROE) are higher than the benchmark’s. ROE is an efficiency metric that measures how much profit a company makes on every rupee shareholders have invested in it.

Motilal Oswal takes a different approach, with a tilt towards growth. "We focus exclusively on growth stocks. For our contrarian picks, we look for ideas where consensus estimates fall short and where we see higher relative growth in the companies," said Bhalchandra Shinde, Fund Manager of Motilal Oswal Mutual Fund.

Sector bets

The different approaches also show up in sector preferences.

Kotak’s Contra Fund is overweight on banking, where Kurian expects balance-sheet growth to pick up. Monthly data from the Reserve Bank of India (RBI) already shows faster loan and deposit growth. Liquidity may squeeze bank margins in the near term, but she expects them to bottom out and improve as banks lend out the deposits. With credit costs under control, she sees good visibility on earnings for next year, while valuations are well below their long-term averages.

Shinde favours banks poised to benefit from the rate-hike cycle, characterizing the banking sector as a resilient, non-AI theme backed by expanding credit growth and improving margins.

Kurian is also positive on hospitals, which have corrected recently. She expects steady demand for tertiary healthcare, continued bed additions and healthy occupancy to support growth despite some near-term regulatory uncertainty. She is positive on autos as well. Higher input costs may hurt margins in the near term, but demand remains strong, and a possible Pay Commission award next year could add to demand.

Within AI, Shinde prefers data centres and the capital expenditure linked to them over the AI platforms that most investors are focused on. In pharma, he sees opportunities in glucagon-like peptide-1 (GLP-1) drugs, used to treat diabetes and obesity. He considers this a contra opportunity because he believes the potential is not fully factored in from the perspective of Indian pharma companies.

In IT, Shinde avoids a sector-wide bet because large companies still face overhangs. Instead, he prefers select mid-cap IT companies that are benefiting from AI infrastructure.

Both Kurian and Shinde are avoiding insurance, even though the sector has fallen after recent regulatory changes. “Until we see growth coming back and earnings improving, we have been staying away from the sector,” Kurian said. Shinde added that even though insurance stocks have seen correction, the regulatory overhang is still there.

Takeaways

Contra funds are style-based investments and are better suited to the satellite part of a portfolio than the core.

“For core portfolio, investors should still stick with diversified fund categories like flexicap as it is both market-cap and style-agnostic,” said Surya Bhatia, financial advisor at Asset Managers.

If investors still want to consider a style-based category like the contra fund category, look for funds with longer track-record or fund management teams that have demonstrated the ability to take contrarian calls on a consistent basis. Remember, a contra investment thesis may take time to play out, hence investors should only look at such funds if they have long investment horizons.