Contra Funds: Investing against the market

Contrary to perception, investing in contrarian funds does not involve an overly complex strategy. Yet, these are consistently shunned by investors. To understand why, one must first understand the philosophy behind contrarian investing.

It involves buying into companies that are being rejected by investors because of short-term concerns. Since these stocks are out of favour, one can buy them cheap relative to their long-term fundamental values. Therefore, the reward-risk balance is quite attractive for investors.

"However, people tend to chase what is popular in the market, which, therefore, is also expensive," says the senior fund manager at Tata Contra Fund. The reward-risk proposition is unfavourable if stocks are bought at high valuations. Take the technology boom in 1999-2000, when tech stocks were in demand. Their valuations were so high that even top performers have not been able to repeat the peak prices of that period. For instance, Wipro today quotes at only half its peak price of February 2000 (BSE India) despite having performed extremely well over the past 10 years. Hence, a contrarian approach is advisable whenever the market goes from cheap to fairly valued or is slightly rich in valuations, according to Vetri Subramaniam, head of equity funds, Religare Mutual Fund.

So if one buys stocks trading at a discount to profit, good returns are almost a given. Consider the banking sector during the downturn in 2008, when stocks of financial companies had plummeted. Most contra funds had bought banking stocks at the time owing to the strong fundamentals of the Indian banking system and their discounted valuations.

Tata Contra bought HDFC Bank, which was punished by the market because of the foreign institutional investor (FII) ownership of its shares during this period. It is currently the top holding in the fund's portfolio.

Religare Contra Fund's exposure to metal companies during the trough last year, as well as its overweight stance in real estate through stocks like Phoenix and Mahindra Lifespace, enabled the fund to give a superior performance. Now, contra fund managers are bullish on the telecom industry due to the negative view of the sector following intense competition in this space. Despite the BSE Sensex having touched a yearly high of 18,287, sectors such as telecom continue to remain beaten down. This is an opportunity for contrarian investing. In spite of the fact that stocks in this sector are under selling pressure, they could offer good long-term value, says the Tata Contra Fund senior manager. Contrarian strategies and when they work There are several investment strategies that are followed by contra fund managers.

In the Religare Contra Fund, Subramaniam specifically looks for companies that have valuable assets or ones that are in a turnaround phase, and where the core business is their intrinsic strength. He also looks for absolute and cheap valuations relative to the sector while screening for underperformance, and limited public holding relative to the market. Pankaj Gupta, fund manager, Magnum Contra Fund, invests in companies that project a difference in market perception and their fundamentals.

Although these funds voice their contrarian bets, they end up knitting a portfolio that has largecap stocks, replicating a diversified equity portfolio, says Fahima Shaikh, research analyst, IIFL. Defending this strategy, Subramaniam says the contrarian approach does not only mean going against the market. "Our contrarian approach is supported by a willingness to take on risk early," he says.

Tata Tea, for instance, became the top holding in the Religare Contra Fund on account of its cheap valuation and limited public holding, says Subramaniam. Reliance Industries, ONGC and Reliance Infra positions were added to (or increased in) the fund due to their underperformance relative to the market. Similarly, a stock such as Apollo Hospitals is a top holding as it is in a sector that has potential for growth but has been underperforming the market for some years. Bad news can strike even the bluest of blue-chip companies, says the Tata fund manager.

At such times, contra funds buy into companies that have strong fundamentals but are discounted because of short-term performance issues, he adds. So, even though the portfolio has stocks that are blue-chips, they were bought when their stocks were struggling in the market. Fund managers are of the opinion that this is an evergreen strategy and works in all market phases.

This is because we don't buy into broad markets but individual companies, and at any given time, some sectors or companies are out of favour, says the Tata fund manager. However, the philosophy may not work well when the market goes from being slightly rich to extravagantly overpriced in terms of valuations. This explains why they were overlooked for their diversified counterparts during the bull market between 2004 and 2008.

Investors chased returns and any stock that did not reward them within a 3-6-month period was, more often than not, dumped. In fact, the category manages a meagre Rs 350 crore in AUM, which is barely 5% of the total equity category. Should you invest in contra funds? According to Shaikh, one would be better off investing in a basket of blue-chip funds that have a proven track record with strong creden-tials. Catching a trend before the
herd is not possible at every market cycle.

Having said that, contra funds expose a part of the portfolio to defensive stocks, which enable them to sail smoothly during the trough, she adds. During the previous down phase, between January 2008 and March 2009, the contra fund category delivered a negative return of 56%, even as the BSE-200 fell by 64%. UTI Contra Fund contained its downside to 45%, while SBI Contra and Kotak Contra fell by 53% and 51%, respectively, during the same phase.

This has allowed the funds to outperform in the past few years. While Tata Contra Fund has been the best performing fund in the category, the Religare and ING Contra funds have outperformed the BSE Sensex and the average diversified equity category over the past one year. These funds have also done well as far as 3-year returns are concerned.

On the flip side, this defensive approach makes these funds underperformers during a bull phase. "If an investor is looking to make a quick buck in 3-6 months by investing in momentum stocks, then this is not the fund for him," says the Tata fund manager.

 In the contrarian theme, one is always trying to get the reward-risk balance in one's favour. So, it is best for investors who have a low risk appetite and a suitable investment horizon as advised for any diversified equity fund. A five-year horizon would be ideal for an equity fund because equity markets can be volatile in the short term, says Relekar. Such a period helps an investor capture the gains from the underlying business growth of a company even if he is caught on the wrong side of volatility.

Also, the risk of the stock calls not panning out is quite high owing to the contrarian strategy that such funds adopt. There are times when a sector or a stock takes a long duration to turn around; there's also the possibility that it never finds favour in the market.

For instance, Magnum Contra Fund's high exposure to telecommunication stocks has hurt the fund's performance of late, as have the calls taken within the energy sector, such as on oil marketing companies. So, pick out-of-favour companies with strong fundamentals and you are bound to land some winners in due course. Going against the market is not such a difficult strategy after all.