Should you invest in contra funds?

Summary

Contra funds look for opportunities, which the market might be ignoring. However, fund managers approach contra investing with their own filters. 

Fund houses are launching contra funds as several sectors face disruption amid global uncertainty. Bandhan Asset Management Company, ICICI Prudential AMC and Motilal Oswal AMC have recently launched contra funds. WhiteOak Capital AMC, a newer fund house, has also filed for one with Sebi.

Here is how contra funds work and what investors should consider before investing.

What is contrarian investing?

A contra fund buys stocks or sectors that the market has turned away from. These may have underperformed the broader market, trade below their historical valuations or simply be overlooked by investors. The fund bets that the market is too pessimistic and that the stock will be re-rated when the business recovers or sentiment improves.

This approach overlaps with value investing, but the two are not the same. “All value is contrarian. Not all contrarian investing is value,” said Sirshendu Basu, head of product management and strategy at Bandhan AMC.

Value investing starts with the numbers. It examines earnings, book value and cash flows to identify businesses trading below a reasonable estimate of their worth. Contra investing starts with a potential trigger, such as a cyclical downturn, regulatory overhang or technology scare. The premise is that the market has misjudged what happens next.

S. Naren, executive director and chief investment officer at ICICI Prudential AMC, explained the distinction with an example. A value fund cannot buy a quick-commerce company simply because its stock has underperformed, as it is a growth business whose valuation does not price in low expectations. A contra fund can invest in it if there is a genuine opportunity.

“Contrarian investing can include value, growth or quality stocks at different points in time,” he said. For instance, quality stocks have underperformed for six years. In 2020, they would not have been considered as a contrarian play.

Spotting turnarounds

The two styles also carry different risks.

A value fund faces the risk of a value trap, where a stock appears undervalued but is actually cheap because its business fundamentals are deteriorating permanently.

“A contra fund faces the risk of a contrarian thesis failing which is investing against prevailing market sentiment on the expectation that the market will eventually recognise an opportunity. However, sometimes the market consensus is right, and the anticipated recovery or re-rating never materializes,” said Ravi Kumar TV, co-founder of Gaining Ground Investment Services.