‘You cannot be a blind contrarian'

There are two kinds of stocks in the listed universe now. There is a quality bucket and then there is everything else. My job is to look for opportunities in ‘everything else' says Mr Sankaran Naren , CIO, ICICI Prudential AMC. In an interview with Business Line, Mr Naren explains why being contrarian pays off in the long run but warns investors against being ‘blindly' contrarian.

Excerpts from the interview:

During our last meeting you said being contrarian was the only way to outperform the market. Do you think being contrarian has worked in the last one year?

If you take an example of telecom, it was the sector that outperformed in the last one year, delivering 30-40 per cent. Now that was essentially being contrarian. In infrastructure, though, it has not worked. But that does not mean it will not help being a contrarian.

As one of my gurus, Mr Howard Marks, put it, you may not have much choice but to be contrarian when you are a big fund manager, or rather, managing a big pool of money. You cannot do what everyone else is doing and still hope to make money.

In 2007, it was technology and pharma that were contrarian picks, in 2010 what worked was telecom. We were underweight on banks last year and that was essentially a contrarian call, and that has also worked.

But in India, given that investors look at one-year performance for investing, does the contrarian theme pay-off that soon?

It may play out in a year or sometimes take two to three, but it is not enough to be only contrarian. It is important to buy something that has essential long-term value. In 2009 or 2008, you could have bought a certain set of stocks which are almost no longer in existence. So, if you look at contrarian picks, you should also have an idea about the value of the company. Otherwise, you are playing blind.

Does playing contrarian not amount to taking too much risk in the Indian context, when one could easily have got similar returns sooner?

If you go back to 2007, you could have held a technology or pharma stock that underperformed the market by 30-40 per cent that year. So would you say technology and pharma stocks were risky then? No. Did they underperform? Yes they did. So it is difficult to predict. If you see today's environment you see all the quality stocks trading at huge premium to all other stocks. Now, in my framework of investing, it is difficult to buy those quality stocks. Quality stocks are pricing in everything being nice whereas I get a set of stocks across the market segment today which are very cheap and nothing is priced in; so if something works, it will go up.

Does ‘high quality' basically mean large-caps or is it subjective?

No, if you see some of the FMCG stocks in the small-cap segment, they are also trading at high valuations. So, at this point of time it is very clear that what the market deserves is the quality bucket and then there is everything else. Now the job for us is to look at ‘everything else'.

You had situations where regulatory developments or scams or even a tax raid resulted in stocks being beaten down 20-30 per cent. Are there opportunities in these stocks or would you stay away?

I repeat that you cannot be a blind contrarian. So, you should have a definition of the value in a company. For example, there was a pharma stock which had three different problems. They had a problem in one of their patented drugs. They had a problem in one of their facilities and they had a problem in a takeover. That was a classy company. So we said there is value in that company and played contrarian. In some of the other companies which have problems, like an income-tax raid, you have to first understand the company and be able to ascribe some value to it. When we took our own call on telecom, we primarily took it because understood that company and said it will be a winner. So, play contrarian but along with that have a definition of what is its value and see if you are comfortable with such value.

Though the Sensex PE isn't very high now, there is worry that the earnings part will keep shrinking. What is your view on how earnings will pan out?

I worry when Sensex PE goes up and commodity EPS goes up. When commodities go down and Sensex EPS goes down I am very comfortable. Because I feel that the way the Sensex is organised, there is lot of money made because of the weight given to commodities.

Now if, for example, crude oil was lower or metal prices were lower and Sensex EPS were lower, I could give a higher PE. Whereas tomorrow if crude oil goes to $120 and Sensex EPS is high, I cannot give it a high PE.

So the market has a problem with ascribing too much of value to Sensex EPS. You have to see EPS being okay in stocks outside commodities. That is why you will see that, over a period of time, people ascribing multiples to Sensex EPS have not gone right in India because Sensex EPS is too correlated with commodity prices. So, it is the quality of earnings that matter.

Should investors too need to take a more active approach to mid-cap funds, given that their performance chart has been swinging a lot?

In my reading, yes. In mid-cap funds the critical threshold of size is lower than a large-cap fund and size does play a role as has been proved globally.

That is one of the reasons why in our Discovery fund (with high mid-cap exposure) we bought some large-caps last year where we believed there was value.

Because we found that if we have to make this fund a good long-term fund we need to have some large-caps. This challenge of size is always going to be there in countries like India and we have seen it in the past also.

In what segments of the market do you see scope for a contrarian approach?

You see, in 2007, being contrarian was very easy because the quality of stocks you bought on a contrarian basis was very good. Now the cheapest stocks are not the quality stocks.

So the challenge for us to do research and not go wrong now is much higher than in 2007. But having said that, I think there is no choice, because if you are going to buy stocks at 25 PE, what we have seen over a period of time is that you get maximum returns by both ‘E' (earnings) going up and ‘PE' going up. But there are a set of stocks where there is no chance of the PE going up so it can only go up to the extent of ‘E' going up.

So it means that the return expectation on those set of stocks is that much lower.

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