In 1559 when the first tulip bulbs arrived in Holland and Germany, people fell in love with the exotic Turkish flowers. Soon speculators entered the tulip market purely for monetary gain and trading tulips became popular. Speculation led to high trading volumes and merchants and shopkeepers began to vie with one another for tulip bulbs.
Flower power. At the height of the tulip mania, in 1635, single tulip bulbs were being exchanged for as much as four tons of wheat, silver cups, two casks of wine and four oxen. It was bizarre as people sold homes, livestock, everything for the privilege of owning tulips, on the expectation that prices would continue to rise.
By 1636, tulips were being traded like stocks on the Amsterdam stock exchange. Smart players began to liquidate their tulip holdings as prices rose. Tulip prices weakened rapidly. Panic seized the market. Within six weeks, tulip prices crashed by a catastrophic 90 per cent and more.
Obviously tulips have little practical value. So, what could cause people to behave so irrationally? Nobody has a definitive answer but over the centuries, we’ve seen this collective insanity time and again. It’s a herd mentality–everybody rushes off to buy something and then suddenly, everybody stampedes in the opposite direction!
Economics theory is based on the assumption that individuals act rationally and consider all available information before making a decision. However, the tulip-mania and all the financial bubbles that have followed offer strong evidence that this is often not true.
All things being equal, in a rational market the fundamentals of a company should determine its market price. However investors usually overreact, often wildly, first pushing prices up too high and then pushing them too low.
A recent example can be culled from Infosys. In the first quarter of this fiscal, it delivered slightly disappointing results though the longterm prospects remained benign. Everybody sold and the stock price fell to Rs 1,900. Investors who kept their heads and bought at Rs 1,900 soon saw the price shooting back to Rs 2,650.
Similarly, a stock like Bharti Televentures Ltd, which had huge start up costs and capital outlay, offered windfall gains to those who recognised its intrinsic value. The stock traded below Rs 50 in 2003. Now it is priced at over Rs 300.
Most investors chase momentum and focus on rising stocks, rejecting those that fall. This causes them to overlook quality companies at low prices. This irrational behavior provides excellent opportunities if you can detach yourself from the crowd and move in the opposite direction.
This is the underlying rationale of ‘contrarian investing’. Contrarians do not risk money by blindly following the crowd; they look for opportunities when crowds act irrationally. Historically, contrarian strategy has paid off. The greatest investment guru, Benjamin Graham and his greatest chela, Warren Buffet are contrarians.
The mutual fund industry is eager to employ this strategy. Kotak MF and Tata MF have recently launched contra funds and the SBI Magnum Contra fund launched in July 1999 is one of the best performing diversified equity funds.
Conceptually, contrarian investing looks easy; buy when others are selling and sell when they are buying. But it’s easier said than done. Says Nitin Jain, fund manager SBI Mutual fund: "To think differently is certainly not easy. You might end up buying stocks in a contrarian manner and might just have to wait too long till others buy. Thus, your fund may not have performed at all for 2-3 months. It’s a skill to pick stocks ahead of others."
Picking stock ahead of others is what SBI’s Magnum Contra has done well. They bought top holdings like Cipla and BHEL some nine months ago. SBI’s Magnum Contra has been a consistent top performer. It has yielded 92.8 per cent over one year, 81.8 per cent for three years and 48.2 per cent on a 5-year CAGR basis. Jain further explains that contrarian investing involves ignoring over-heated sectors and picking the ignored ones.
Spot the difference
Contrarian investing is similar to value investing. A value investor also invests in undervalued stocks with long term potential. So what’s different?
Nilesh Shah, President Kotak Mutual Fund: "Value investors look more at the valuations such as the P/E multiples, Price/Book value etc. The focus is thus on value. A contrarian approach involves picking up quality stocks when the markets are ignoring them purely for temporary reasons like changes in government policy, competitive environment or the business environment."
The top picks in Kotak Contra are I-flex, PNB, EID Parry and Tata Steel. I-flex enjoys a lower valuation compared to its peers and the fact that Oracle has a stake could mean huge growth in the order book of I-flex. Most investors sold the stock after the rise once the Oracle news became public. Kotak bought it then, reviewing the long term potential.
The markets also seem to have ignored the growth potential in PNB and bought it purely for treasury profits. Similarly, EID Parry is not only a sugar business but it also has investments in fertilisers. These stocks are contra picks. Will they deliver? Only time can tell. Contra funds warrant a medium to long term horizon.
Tata Mutual Fund is the most recent entrant in the contrarian space. Says Ved Prakash Chaturvedi, Tata Mutual Fund "Contra strategy works well in an over heated market. Post the bull run of 2000, people who had invested in sectors like auto, metals, cement and engineering taking a contrarian view fared better. Over the long term, contra funds can deliver top returns". For their Contra fund, sectors like FMCG, fertilisers, tractors, pharma and oil refining and marketing are Tata Mutual Fund favourites.
Bottom-line
Several fund managers have demonstrated that they can implement the contrarian strategy effectively. The success of contrarian management depends on sticking consistently to the philosophy. Shah explains, "Over a period of time, what matters sticking to the contrarian philosophy and delivering good returns at the same time. The challenge is to get that balance".
Typically, contrarian investing involves less initial risk, since purchase prices are usually at the low end of valuations. Historically, stock markets move in cycles. The contrarian concept, like any other investment philosophy, will cycle in and out of favour. Diversification cannot be over-emphasised. Putting all your eggs in one basket is dangerous. The contrarian approach should be adopted only as one component of a diversified portfolio.