Mumbai Capital

Better be safe than sorry with a ‘contra’ investment

One of the best sources of idea generation across genres of investors ranging from sophisticated fund managers to amateur retail investors is to look at stocks that have fallen the most in the past one year and are trading at 52-week lows. The list is huge and it is quite common to see an avid stock market follower go through the list to identify investment opportunities.

This style of investment is referred as the ‘contra style’, wherein beaten-down stocks are identified, studied and bought if there is conviction that the sharp fall is unjustified and there remains huge value in the stock.

It also helps that such stocks generally have lower investor interest and are under-owned, and if the investment argument is proved right, the returns can be much higher than the market.

However, the risk is high and there remains a high possibility that the stock may remain at these levels. It is possible that this strategy may not work in some cases; the reasons could be many.

In the current environment, it is likely that commodity stocks are in the last quartile, and most commodity stocks perform only when the underlying commodity outperforms. For example, the stock of an aluminium company will start performing only when there is a sustained rise in aluminium prices. One clearly needs to monitor the prices of the commodity to get it right on commodity stocks.

There could also be a set of companies whose business dynamics have changed completely. They may not survive or earn profits to justify the cost of capital in the current environment. We have examples of state-run telecom companies that have been wiped out in competition and face the risk of extinction. Another example could be a public sector company in the power generation equipment sector.

There will always be a set of companies where the promoter’s corporate governance is suspect. Markets will always punish the stock and seasoned investors will avoid it. Such stocks also run the risk of being de-rated permanently unless the management changes for the better.

In every cycle, at the top there is always a sector where the price-to-earnings ratio (PE ratio) is at stratospheric levels. In most cases, the stocks correct over a long period of time once the euphoria is over. Prime examples are the information technology boom in 2000 and the infrastructure boom in 2007. It took four to five years even for well-established blue chips in these sectors to recover to the earlier-level prices; a majority of stocks in these sectors have not seen the previous highs of the last cycle.

The success rate in this strategy is not very high and investors must not be tempted to invest in stocks just because they are quoting at yearly lows. However, if the stocks are carefully identified at the right time, the risk reward is very high. There are many factors that should be kept in mind while choosing such stocks. In case of commodity stocks, one has to see the underlying dynamics of the commodity that the stocks represent: the global demand supply and inventory, and the current cost curve before taking a decision to invest.

Care must be taken to avoid investments in companies whose competitive advantage has been eroded and chances of making reasonable return on capital even in the medium term is very limited. Trading gains in such stocks may not be ruled out but over a medium term, these stocks will tend to underperform the market.

There could be a class of companies which may be going through temporary crisis such as a global pharmaceutical company receiving warning letters from the US FDA over its plant, which impacts the growth or results in a temporary closure of plants in case of manufacturing companies. Care must be taken to study the reasons for the temporary lull in operations and the seriousness of the situation.

In case of companies with poor corporate governance, utmost care must be taken -- these classes of companies will appear cheap and there will be a temptation to invest in these categories of companies. However, there could be a stray incidence of a company changing for the better. In these cases, the returns could be substantial.

Risk-reward strategy

To conclude, the contra strategy is a risk-reward strategy which calls for a detailed study of companies not performing well in the markets. Investments should be attempted only after a thorough analysis of the factors causing the stock prices to fall and in companies with a good track record.

The writer is Executive Vice President, Equity Fund Manager, UTI Mutual Fund

Beaten-down stocks are bought if the sharp fall is unjustified and there is still huge value in the stock

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Printable version | Apr 20, 2021 3:54:34 AM |

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