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Profiting from special situations

Sankaran Naren discusses the market outlook and dives into the nuances of special-situations investing to flag off the New Year

Profiting from special situations

You have been saying for the last couple of years that valuations of the Indian stock market are not too attractive. You have been recommending that new investors step into equities through your dynamic or balanced-advantage funds. Have you now changed that view?

I am cautiously optimistic on the markets. I think 2018 offered very few opportunities for anyone to make money. If you picked anything other than a few benchmark stocks, you lost money. 2018 was a year in which if you invested in a debt fund, you made more money than in equity funds.

But I think 2019 will offer more stock-selection opportunities. I see opportunities for investing in select small caps and mid caps which are beaten down. I believe it is the aggregate market which is fairly valued today. But there are many individual components that have become cheap after the big correction. Therefore, I believe that 2019 will not be a year to look at the aggregates. It will be a stock pickers' market.

What is your reading of the global situation? Has the withdrawal of global liquidity and rising rates played out for India? Or are we just at the beginning of a big correction?
I think that until quantitative easing in the US is completely wound down, the tightening of global liquidity and markets will continue. Until it is over, we cannot say we are out of the woods. But the one positive thing that has worked in favour of India is the retreat of global oil prices recently. If oil prices had not fallen, India would be in a much worse position and the conversation we are having today would be far more negative.

Because oil prices have crashed, Indian macros are now looking good. The fall in oil prices has also been the reason why foreign investor pull-outs have moderated somewhat in recent months. October, for instance, saw very significant FPI pullouts. The positive thing is that once oil prices began to fall, no one wanted to sell India.

You have told me in the past that you like to buy sectors or themes that attract the most negative headlines at any given point in time. What would they be today?
PSU stocks are one theme on which we are clearly positive. You will be able to see that across our portfolios at the end of December.

What is your view on the mid- and small-cap segments of the market? They have suffered the steepest corrections. But if you look at trailing returns on both the mid-cap and small-cap category over three or five years, they are still quite high. Should investors stay off?
No, I think this needs to be a completely stock-specific decision. In our multi-cap funds, we have been adding quite a few mid- and small-cap stocks which have become quite reasonably valued after the correction. We are out of that phase in the markets where everything looked expensive. But the reality is that 2019 will be a volatile year due to both local and global factors. So, I think that in 2019, investors will have to brace for risks from volatility, but the risks from over-valuation have abated.

We are not starting off 2019 with an overvalued market as we did in 2018. But we do see several events that can induce market volatility. That is why, the thought of a special-situations fund to capitalise on the opportunities arising out of such market dislocations.

You have just launched ICICI Prudential India Opportunities Fund, which plays on the special-situations theme. You already have a value fund under your fold and contrarian investing is your trademark. How is special-situations investing different from value or contrarian investing?
The way we look at contrarian investing is that if others are doing X, you do Y. For example, let's take the NBFC issue that happened recently. The logical thing from a contrarian perspective would be to go and buy NBFCs when they were in crisis. On the other hand, in special-situations investing, you need not do contrarian stuff. If there is an issue with NBFCs and you think that the small regional banks may be the beneficiaries of that, you buy them. This is how we look at special-situations investing. You buy a stock or sector not necessarily because it is cheap or out of favour but because there has been a trigger that now makes it attractive.

In value investing, you buy something that is cheap compared to its intrinsic value. To give an instance, neither Nestle India nor Maruti Suzuki would be stocks that figure in a value investor's buy list, given their relatively high valuations. But these stocks have offered entry points based on special situations in recent years. When Nestle India faced a regulatory issue around Maggi in 2017 or when Maruti faced a strike at its Manesar unit in 2012, they offered buying opportunities for special-situations investors.

Globally also, contrarian funds, special-situation funds and value funds are three distinct categories. That's why we decided to look at special situations as a strategy because this category has done very well for big fund houses, like Fidelity, globally.

The fund's positioning becomes clearer if I explain it this way. ICICI Prudential offers some low-risk, low-volatility products in equity. Bluechip Fund and the Balanced Advantage Fund fall in this category. Then there are equity funds which can suffer big negative returns at times, which we term risky. Small-cap funds and infrastructure funds, for example, are risky funds. Then, there are those funds that are volatile but not necessarily risky. Such funds do not deliver performance that is anywhere close to the benchmark in the short run. But in the long run, they can outperform. A special-situations fund would, to my mind, be a volatile fund. This fund will have a high active share. It would be wrong for people to expect it to move in line with the benchmark in the short run.

Is special-situations investing about capitalising on event-based situations such as when a company undergoes a merger, stock split or demerger?
I would like to define it as looking for opportunities arising out of stock or market dislocation. Such dislocations are quite common. Whether it is GST, demonetisation, US-China trade war, NBFC issue or worries about a China collapse, all of them can offer opportunities.

The domestic mutual fund industry has become very large today and much of the money is invested through the growth and quality framework. Therefore, when special-situations develop, typically many of the growth and quality funds want to exit those stocks. There are relatively few counter-parties in such situations. That's where we would like to step in.

When there are company-specific dislocations such as a demerger, strike or regulatory issue, it is easier to spot such opportunities. But is it really possible to decipher who will benefit from macro-level changes? For instance, was it possible during demonetisation to say who would benefit from it?
Even the man on the street can spot stock-specific special situations. That's why you find that special-situations opportunities with respect to individual companies, like the Maggi issue, do not last too long. Everyone knows the strength of the company and the brand. The window of opportunity is also very short. That lowers the scope for alpha from such opportunities. The special situations that come from macro changes such as demonetisation or government policy will always be more complex. That's why it would be better for us to play these opportunities. If we are able to read the macro opportunities right, the payoffs are much higher.

Do you have examples from the past where you have detected buying opportunities after macro events and made money out of them?
In 2012-13, we saw a macro special situation when the current account deficit went up substantially. We bought both tech and pharma stocks then, anticipating rupee depreciation.

Similarly, take the issue of non-performing loans, or NPLs, for banks. For a very long time, right from 2010, we were underweight banks because we saw the issue persisting. In fact, we were under-weight on public-sector banks right from 2011 to 2017, though the NPL issue did not show up fully in the balance sheet of banks until 2016.

In 2011 itself, large infrastructure players in India started showing signs of stress but at that time this didn't reflect in the performance of the banks that lent to them. But it was evident to us that the NPL issue with large infrastructure borrowers would have to reflect in the numbers of the public-sector banks at some point in time and therefore we avoided them. Sometimes you can identify special situations ahead of the market through the research that you do. Are such opportunities obvious? No. That is why we think we can create alpha through such calls.