"I'm looking at the markets more positively"

Only a handful of mutual funds follow a contrarian investing style, and Invesco India Contra Fund is one such fund. Having generated superior returns for its investors in the long term, we wanted to know how contrarian strategies have kept the fund ticking for so long.

For that, we got in touch with Taher Badshah. There's no better person to speak to than him, as he is the fund manager and the CIO of Invesco Mutual Fund. He shares his insights on market valuation, growth vs value style of investing, and in which pockets of the market he is currently finding contrarian opportunities.

The current economic situation is uncertain, with India's interest rates stabilising while developed nations continue to raise rates. The potential for a recession in the US is still a worry. Despite this, Indian markets are at an all-time high, with even FIIs showing confidence. What's your take on the current market sentiment?
At the end of the last calendar year, we started off with a conservative expectation about the market. There were a few reasons which made us believe that it will be a year of readjustment post the COVID-related era of 2021-22 and markets might end up being range bound.

However, many things have changed and are looking a lot more favourable compared to what they were at the start of last year.

• Growth has not turned out to be as bad as what the market started to anticipate. Because of flat performance of the market for six months of this year, our relative valuations have actually become a lot cheaper and more desirable compared to what they were six months ago. The premiums have now come back to average and are a lot more appetising than what they were at that time. Now we're not sticking like a sore thumb between other emerging markets and developed markets.
  
• Consumption is still on the weaker footing, but it has not fallen off a cliff, at least urban consumption. On the other hand, the investment cycle got even stronger (led by the public sector investments in core areas of the economy, in transport, power, defence, railways, and logistics). Alongside the investment cycle, there is an embedded real estate cycle which, after a very long time, is also gaining strength. And things look reasonably sustainable, as most of the building blocks required for a good investment cycle to unfold are in place for India.
  
• Fortunately, or unfortunately, China has not turned out to be as roaring an economy as was expected. This has led to two things. One is that the fear that China would stoke inflation has not happened for the good of India. And commodity prices have, in fact, come down, which is good news for us. As a result, the investor attention, which in the early part of the year went to China, has come back more towards India. And that's why there has been a resumption of flows in the last few months.
  
• There was an expectation that India will see more interest rate hikes but as it turns out, the RBI had chosen to pause in the early part of this year against the expectation that it will pause in the second half. The trends in real interest rates and inflation (even though agriculture inflation is a concern, overall, things look relatively stable) suggest a higher likelihood of rates turning down rather than going up from here.

So, all these things have made the case look more attractive. To our good fortune, the expected readjustment process has lasted less than what we had thought. And few of the things have turned favourable for us.

There are a couple of things which are still nagging. The rural part of the story is not contributing as much, even though the monsoon has not been as bad as expected. However, I think it's a matter of time.

As rural household incomes are more sensitive to inflation than urban households, if the path of inflation becomes moderate, and part of rates is downward, then maybe somewhere in 2024, I would expect even rural consumption to start getting better. So, then, we'll have most of India's engines firing. On a net basis, I would say that I'm looking at the markets more positively. While there are pockets of overvaluation, I think valuations are not as demanding and we will start seeing earnings upgrade cycles coming through in 2024.

Owing to a massive rally in the mid and small-cap segments, investors are upbeat and have poured significant money into these funds. What's your view on the valuations in these segments? Are we in a state of euphoria?
I think it's a mix. While there are some pockets which have become a little euphoric or moved very fast in a shorter period of time, it's not that the whole space is completely off investment limits. There are some pockets which are a little overextended but we can see some earnings surprises from these companies. So, what is looking expensive may not be as expensive.

The returns have been obviously strong. In the last six months, the mid- and small-cap index returns in the last calendar year itself must be about 20 per cent. But despite this, the five-year CAGR returns for the mid- and small-cap index are about 18 per cent and 15 per cent, respectively, which, if you compare in the past cycles of mid- and small-cap rallies, have aggregated more like 25 per cent on a five-year basis.

So, while the near term has been strong, the five years haven't been as strong yet. So, there is a movement; mid-caps and small-caps are typically more levered to the domestic economic cycle. So, if the domestic economic cycle does well, or is likely to do well, mid- and small-caps generally tend to do well. We're looking at a reasonably strong economic cycle for India, unfolding in the next five years compared to the prior five years. And that makes a good case for mid- and small-caps.

Lastly, I think the breadth of opportunities in mid- and small-caps is widening and new types of businesses are emerging. Some of them will become leaders in their own way, and mid- and small-cap investing at one level is about that, i.e., essentially identifying companies in the early stages of the life cycle, which, over time, will convert into mid-size businesses or large-size businesses. And I think to that extent, the opportunity set is expanding.

Having said that, one has to be judicious and check what they're overpaying or underpaying. But it still isn't a situation where we completely avoid some pockets just because there is a lot of action in the market. I think it's still in the initial phases. While we can very well have pullbacks, this isn't a story which is on the verge of collapsing or is not built on sound fundamentals.

Post-COVID, we have seen the value style coming back in vogue while growth-style funds took a backseat. This year has been sort of mixed - both the investing styles seem to be doing well, though value-oriented funds still appear to have an edge. How do you think the trend in this cycle would play out in the near-term?
From the standpoint of India, at one level, everything is growth. There's very little pure value, which is generally the case in some of the low-growth economies or developed economies where there are larger identifiable components of value companies, which are high dividend yields, low growth through utility type of sectors.

In our experience of running the contra strategy, we see that it does very well at times when the economic cycle is favourable, it outperforms the indices quite meaningfully because things around the industrial and investment cycle (which are typically the value pockets of the market in India) start doing well. And this is what is happening right now. So, I feel we are probably at a stage where inflation will be somewhat higher in general compared to the past. While it may be lower than last year, it will still be on a higher level. Interest rates may come off, but it may still be higher than what they were over the last five years.

But if this coincides with a good domestic economic and investment cycle, it typically bodes well for Contra credit strategies. Therefore, I would like to think that as we are positive about the economic cycle, it gives a better chance for value-oriented strategies like the Contra fund to outperform.

Given the current economic scenario, what sectors or themes are currently looking out of favour and thus attractive to you? Conversely, which sectors appear to be trading at elevated valuations?
By and large, we are buying what is desired out of this mandate, i.e., pessimism. The clear pessimistic pockets of the market include Technology, some parts of Consumption (value retail and quick service restaurant industry), some parts of Pharma. But these are the pockets where we've been overweight for the last six months.

Industrials have been overweight for us since the end of 2020 because, at that time, the value theme was not in favour, interest rates were falling and growth was doing well. So, the industrial sector was actually value or contra.

Now they are getting into a stage where there is euphoria, so we are unwinding because many of these stocks have become growth at unreasonable prices and contra fund, as a matter of discipline, is selling some of those and buying into those which are ignored by the market today.

Thus, we have reduced overweight in Industrials, became overweight in Tech, and have started to also reduce our underweight in Consumption - this is how we are approaching these three main parts of the market.

Then there is Pharma and Healthcare where we have overweight positioning for almost one to one-and-a-half years. But it is now gathering momentum and thereby coming into the eyes of investors. So, there is still growth at a reasonable price for us. But it might become growth at unreasonable prices at some stage. If it does, then it will be moved out. Other than these, there are all bottom-up ideas, which are either Diamonds or Frog Prince.

You can read the full interview here.