Contrarian Investing: Capturing Opportunities in Ignored Market Segments

Author: Manoj E, Mutual Fund Distributor

A series of macro shocks and challenges in the form of geopolitics, global Central Bank actions, AI-led business disruptions, FII outflows and currency depreciation have led to significant mispricing in various segments of the market over the past couple of years. Despite a revival in earnings and reasonable to moderate valuations, many pockets of the market have underperformed significantly over this period.

This mispricing has created opportunities for ‘contrarian’ investors who are willing to look away from crowded trades and momentum picks.

Gaining from mispricing

Leaders can become laggards and vice versa over various timeframes.

Between 2022 and 2024, the Nifty FMCG TRI delivered 99% absolute returns. However, the index fell 28% over the next two years, from 2024-2026. The Nifty Pharma TRI gave -31% returns from 2015-2019. However, the index gained 62% over 2019-20. From 2018 to 2020, the Nifty Mid Small Cap 400 TRI declined 41%, but delivered a staggering 385% over 2020-2024.The takeaway here is that, a disciplined contrarian approach to analysing underperforming segments can help capture their potential outperformance during a cycle reversal.

Indian markets themselves seem to present a contrarian opportunity. Developed and emerging markets managed to deliver anywhere between 7% and 58% in US dollar terms over the past couple of years, while the Nifty 50 has delivered -8% over the same period. Even as US indices such as the S&P 500 have rallied due to a narrow set of AI-driven names from 2024 to date, many lagging segments in the Nifty 500 appear well-placed for a recovery once distortions subside.

Following a process

Contra stock picks are those that are fundamentally strong but are currently out of favour, while having considerable upside potential. They could be turnaround or even special situation plays.

There should be clearly visible strategic advantages emerging in the future.

To identify contrarian picks, fund managers first filter the investment universe by analysing stock price patterns, management transitions, near-term weakness in market sentiment, regulatory changes and the competitive landscape. Only companies having optimal debt levels on their balance sheets are included. Care is taken to research deeper into companies that already have too much institutional ownership, as they may be well-discovered and represent crowded trades.

In cases where sentiments is weak, but earnings are on the mend or in strong revival mode, there are chances of better upside potential. Focus must be given to cases where there is potential for gains from disruptions. Of course, some sector/industry-level disruptions could mean fresh risks to earnings, and such picks are best avoided.

A contra strategy comprises a single factor or a combination of parameters, from value to special situations.

Valuations play a key role in assessing the relative attractiveness of segments or stocks via metrics such as PE, PB and EV/EBITDA. Business cycles are assessed to understand the phase currently in operation via macro indicators. Triggers and market sentiment are other factors that help inform contrarian investment decisions.

The exit strategy for contrarian calls is important. When a contrarian mispricing has evaporated completely, sentiments have decisively shifted, or when better stocks become available, it would be prudent to move out of such picks.