Outperformance is not a reason to sell a stock
Amit Ganatra, Fund Manager, Invesco India Contra Fund discusses the fund's contrarian strategy and reasons for buying and selling stocks.
Sep 17, 2019
Invesco India Contra Fund has a good track record. But the fund's portfolio doesn't look very different from the portfolios of other growth funds. What is the reason for this?
At any given point in time, we strive to maintain at least 60 per cent of this fund's portfolio in contrarian opportunities. Today, in fact, 69-70 per cent of our portfolio is in contrarian opportunities. We look for three types of contrarian opportunities. The first is companies which are in a turnaround phase. These are companies that were very strong in the past but for some reason have fallen on bad times. There is often a change in management which tries to chart a path to profitability. If you can identify such opportunities, there is often a benefit that can come out of both earnings growth and P/E re-rating. In the current portfolio, companies in a turnaround phase have a 20 per cent allocation and include stocks such as India's largest spirits company, India's leading private-sector bank and India's largest hospital chain.
A second bucket, 31 per cent of the portfolio today, relates to companies trading below their fair value. Here, the main buying criterion is the stock's cheapness relative to the market, based on price-to-book, price-to-earnings or other parameters. A couple of years ago, IT companies were cheap relative to markets, today many auto companies fit the bill. A third bucket we like to own is derated growth companies. Sometimes, companies that deliver high growth get derated due to short-term or technical reasons. Maruti getting de-rated because there was a strike a few years ago or HDFC Bank getting derated because of FPIs hitting their investment ceiling are examples. If we feel such a derating is due to short-term reasons, we take advantage. In the current portfolio, companies like Exide Industries fit this description. Today 17-18 per cent of the portfolio belongs here. Generally, I find that not many contrarian or value funds focus on derated growth companies, because these stocks are never cheap on an absolute basis!
So why do we not have 100 per cent of our portfolio in contra opportunities? That's because when we buy some contra opportunities and the stocks appreciate, we don't necessarily sell them immediately. Companies that we bought three years ago as a contra stock may not be contra today, but they would still figure in the portfolio. About 30 percent of our portfolio is in such stocks. To me, they represent the fund's successes! ICICI Bank, which is among the top holdings, today fits this description. We bought it during the bad patch it went through a couple of years ago. Having said this, 100 per cent of our incremental buying tends to be in contrarian stocks only.
How long do you wait for a contrarian bet to pay off?
We typically give three years' time for companies to turn around or revert to fair value. Usually, we find that when we buy stocks that are out of favour, in the first year they underperform. In the second year, they stabilise. And in the third, they begin to do extremely well. Sometimes, however, they may pay off sooner or not at all.
When do you sell a stock?
For us, outperformance is not a reason to sell a stock. We may sell a stock for three reasons. One, we are a process-driven fund house and a fund manager can only buy stocks that are categorised by our process. If my analysts decide to decategorise a company, and remove it from the investment universe we track, then we sell it across our funds. Two, in cases where valuations of a stock do not look justified even if you paint a blue-sky scenario, we exit the stock. Basically, you assess the best-case scenario on earnings and if it still looks expensive, that is a trigger. Three, we sell stocks if we see better opportunities elsewhere. Today, if I could see opportunities to buy auto stocks, I may have to sell some of my older, non-contra bets to create room for them.
What are the signals you look for while selecting contrarian stocks?
To me, underperformance of a stock is a very good signal, whatever the reasons for it. We fundamentally believe in mean reversion. Low valuation is an important criterion relative to the historical average. I typically look at a stock's valuation relative to the 10-year average. To assess valuation, I give more importance to price-to-book than price-to-earnings. The reason is that the P/E is often high for a turnaround company because the earnings are artificially depressed. A combination of price-to-book and return-on-equity often throws up great buy opportunities in my experience. Generally, when looking for contrarian opportunities, we take P&L risk but avoid balance-sheet risks. This ensures that we can wait for a turnaround.
Today there's a slowdown in autos and worries about disruption from EVs. Is this a cyclical problem or a structural one?
On automobiles, my view is that this is a cyclical problem. It is similar to my view on IT two years ago. In the short term, problems affecting an industry always look structural. But if you take a step back and look at the trends, aspiration levels for consumers have not gone down. Kia and Hector had their bookings fill up quickly, indicating that there is always demand for the right product at the right price. Penetration levels for four-wheelers are quite modest in India. I think the problem is one of marginal demand going down due to higher interest rates and non-availability of funds due to the NBFC crisis. This makes it a cyclical issue and not a structural one.
If India had no population growth, an ageing population and high penetration of automobiles, then the problem would be structural. Yes, it is possible for this cycle to last longer than previous ones and for BS-VI and EV disruption to prolong the pain for automakers. But most companies are already BS-VI ready and the cost increase is not as high as originally thought. On EVs, existing OEMs can make the transition.
Globally, apart from Tesla, there is no other new company that is disrupting the older OEMs, which have been successful at launching EVs. The highest selling EV is Nissan Leaf in the US and it comes from a conventional automaker. That tells you that despite short-term disruption, EVs can open up opportunities for OEMs.
What about PSU banks where there has been a rally?
We have stayed away from them because we believe they are up against a structural challenge. Ten years ago, PSU banks had a large share of CASA and were well-capitalised. From that position of strength, they have lost so much ground. They have steadily lost market share and accumulated large NPAs. Therefore, from the current starting point, we believe the outcome cannot be great over the next 10 years.
What's your strategy for Invesco India Tax Plan? Is it also a value-oriented fund?
No, Invesco India Tax Plan is managed with a growth-oriented strategy and a flexi-cap mandate. As of now, we have 70 per cent in large caps, and 25 per cent in mid and small caps. We used to have 85 per cent in large caps a year ago. In October 2018, we thought mid-cap valuations had become more attractive and reduced large-cap weight. But in hindsight, we should probably not have done that as mid and small caps are back to 2018 levels!
But to be honest, following an out-and-out GARP approach is difficult in today's markets. There are three sets of stocks in India as of now. One set is mid and small caps where there's no distinction between growth and value today. Every stock is getting smashed, irrespective of their results. The other set is companies which have weak P&L but very strong balance sheets. Valuations have corrected here. Auto companies fit here. But these can no longer be considered growth companies. The third bucket is companies with strong P&L and strong balance sheets. These have not corrected at all and their valuations are quite steep. In Invesco India Tax Plan, one year ago, we had a lot of such companies. But today, because I don't want the portfolio P/E to shoot up, I often consider companies with weak P&Ls, too. I don't take balance-sheet risks.
Today there's a lot of pessimism about India's economic growth and markets. As a contrarian, do you think this is overdone?
Frankly, it is not our job to second-guess markets. As I see it, this phase offers us the opportunity to buy very attractive growth companies at reasonable valuations. Two years ago, India's IT sector went through such a phase. But because IT was only 10 per cent of the benchmark and it is an external sector, Indian investors did not feel so bad about it. Today, there's negativity about domestic consumption on top of the pessimism about domestic investments, which make up a very large portion of our economy and stock markets. That's why I think the pessimism is now felt more chronically.
But the silver lining is that it is such markets that provide the most attractive return opportunities in the long run. I don't know if people realise this, but most of the returns in equity investing are made from P/E re-rating rather than high earnings growth. In fact, two-thirds of returns come from P/E multiple expansion and only one-third or so from earnings growth.
Therefore, today, if the market offers me cheaper multiples very gladly, I see that as a great opportunity to earn higher returns if I manage to pick the right kind of stocks. You can never have certainty about a company's earnings, no matter how much effort you put into forecasting. But if your entry P/E multiple of a stock is beaten down and is below long-term averages, that offers a possibility of upside with greater certainty. I think on this count, risk-reward is quite favourable today for many stocks.
In the last six months, my portfolio P/E has fallen while my portfolio's average ROE has improved. This may not pay off over the next three or six months but will pay off over the next five years.