Mr Contrarian

Business Line met him at his Mumbai office after a particularly good run for ICICI Prudential’s equity funds. Excerpts from an interesting conversation.

You have an unusual theory. Buy equity when GDP growth is low. Can you explain it?

Yes, if you go back in time and look at which were the best years for equity investing — they were 2001-02, 2002-03 and 2008-09, years in recent history with the lowest economic growth. In contrast, 2007-08, 2009-10 and 2010-11 were years of impressive GDP growth. These were also the best years to sell stocks. People think that one should invest when GDP growth is high. But see where it would have landed them.

Equity is an asset class you invest in when times are bad, and sell when times are good. Yet people usually do the opposite. They like to hear good news before they invest in stocks. If you want an investment when the times are good, try gold. That’s the best asset to buy in good times. Sell gold when times are bad, because that’s when prices peak.

That’s truly contrarian. Many of your competitors have struggled to beat the Sensex but your equity funds did that over the last three years. What’s the secret?

In 2007, we put in place a new research model that completely changed the way we looked at stocks. That year showed us the importance of top-down investing (using the big picture to arrive at stocks to invest in). We had built up big stakes in IT, FMCG and pharma stocks. They lagged the market because of currency appreciation. So, we realised that we needed to do a lot of work on macro factors.

It was based on top-down analysis that we cut exposure to banks in 2009. After the elections, we saw the rise of the current account deficit and a falling savings rate; both are negative for banks. That has really helped us outperform. Once we combined top-down research with careful stock selection, we saw a steady improvement in fund performance.

We also began to look at business cycles more closely. In the last three-four years, we’ve seen many business cycles in materials, from extreme bearishness and to optimism. Timing the cycles well can get you very good returns; but it is an art.

Most managers argue against timing the markets. But you’ve held that this is possible. Some of your funds have juggled successfully between cash and equities to make the most of the yo-yoing markets.

Yes, we do hold higher cash positions in the Dynamic Fund and Volatility Advantage Fund when we feel the stock market is overheated. However, this is not a zero or one kind of choice. We add equities as the market’s valuation (price-to-book value) falls and sell them as it rises. In end-August, no one was bullish, but our Dynamic Fund was 96 per cent invested in stocks. That helped during the rally.

If you use your own judgement to time the market, it doesn’t work. Your behavioural biases start to influence your investing. That’s why it is better to use a quantitative framework.

We find that using price-to-book value works better than the more popular price-earnings (PE) ratio. We add to equities when the price-to-book falls to 2 times and reduce it once it hits 3.6 times.

Today, if you take a top-down view, which themes look the most attractive to invest in?

It is time to follow a value strategy. Today there is a ‘quality’ cycle on. Therefore, we are extremely careful about buying quality stocks. The valuations of FMCG, pharma and IT are very expensive. Consumer stocks trade at 35-40 times, pharma at 25-35 times and technology shares at 20-25 times trailing earnings.

Excluding these three sectors, the market PE is at 15 times. So, there are a number of stocks which are very cheap. Yes, many of these value stocks do require triggers — mines that are to be allocated, exploration clearances to be given or spectrum auctions to be completed. But we are taking a call that some of these issues should be resolved in the next three years.

In many sectors, the capacity utilisation has declined significantly. Over the next three years, if capacity utilisation goes up, profits for these companies will jump without any increase in fixed costs. This is true of sectors such as cement, steel, auto and auto ancillaries. We are staying away from highly leveraged companies and low-value financials. We are positive on export-oriented sectors rather than those relying on domestic consumption.

How do you avoid value ‘traps’? Public sector banks looked cheap months ago when they fell below book value, but they have only gotten cheaper.

The reason we haven’t got into a value trap is that most Indian research analysts are not value investors. They can’t tolerate companies with uncertainty on earnings. Therefore, in the rare cases where the analyst agrees to buy a value stock, the call really works. Let me give you an example. There was a telecom company trading at a ten-year low. It was delisted from the American stock exchange and the shares became available for sale at a very reasonable price in the Indian market. I wanted to buy it. For once, my growth-oriented analyst said it was okay. We picked up decent quantities and the stock went up 50 per cent.

As a contrarian investor, how do you choose which sector to invest in?

I try to see if there are very negative reports about any sector. They immediately pop up on my radar. We also filter listed stocks on the worst and best performers for one year and stocks that are oversold. These help narrow our search.

Mid-cap stocks have hardly participated in this bull market. Is there a contrarian opportunity here too?

Yes. That is why, in the new value fund that we launched, we plan to invest a significant quantum in small- and mid-caps. It is only quality large-caps that are trading at very expensive valuations. Quality mid-caps are available at low valuations and those which we bought have done well.

In recent months, everyone has waited for markets to correct but they haven’t. Foreign institutional investors (FIIs) haven’t pulled out either. Why?

I have also been surprised by the steady inflows from FIIs. The money has not come into India-specific funds. But global emerging market funds are receiving inflows. The other trend is that everyone believes the big commodity super cycle is over. If that is so, among the BRICs, India appears relatively attractive.

Also, with such low global interest rates, sovereign wealth funds are inclined to invest in India. So, in India we keep expecting outflows, but the money isn’t going out. Global investors continue to look at India as a good long-term structural story while we sit here worrying about short-term cyclical factors!

I think retail investor interest in the equity market cannot get any worse. Bank deposits have gone up from Rs 27 lakh crore in 2007 to Rs 71 lakh crore now.

The amount of money that has gone into gold is about Rs 8-10 lakh crore. Real estate is likely to have attracted Rs 30-40 lakh crore. But mutual funds have seen equity assets decline. Trading volumes at the brokerages are pathetic.

So, what will happen if the US Fed does decide to taper?

It is extremely difficult to say. Can FII money still go out? It can. But I do know that this could be the bottom for domestic equity allocations. On flows and the currency, the extent to which we will be affected will depend on the current account deficit. The deficit was at its highest between May and July. Since then the Government has taken a number of steps to contain it and it has contracted quite a lot.

That’s why it makes sense to invest in value stocks. FIIs haven’t heavily invested in these stocks. Everyone is under-invested in them. So, if the market continues upward, that money could get re-allocated.

aarati.k@thehindu.co.in

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