If you are more of a contrarian investor, you would perhaps look for stocks which have been ignored by the market or are currently out of flavour. However, that alone is not the reason why you should invest in such stocks. It’s very important to determine whether such an adverse environment for the concerned stock or sector is temporary and whether it can bounce back.
So, understanding the sector and the specific product is very important, and one should be able to gauge the future potential, as well, i.e., how well it bounces back depending on the management quality and its past track record in downcycles or when faced with adversity. If the balance sheet is stretched, we need to evaluate it based on the future cash flows—whether they would be able to overcome the stress or it will be a downward spiral.
A company having a moat will always be preferred to a commoditised one, as the former will derive a higher valuation when the tables turn.
A contra stock picker also needs to have a lot of patience and confidence in one’s picks. At the same time, if the story is not playing out as per expectation, one should have the courage to call it quits and exit. Patience is of utmost importance, as contra picks tend to take a long time to fructify, and many a time it can create self-doubt as they may underperform when the rest of the market is performing. Thus, you need to have confidence in the picks so that you don’t give up unless there is data to suggest that it’s not working out.
Many a time, investors mistake a 52-week low as a contra investing opportunity, but that may not be the case. A stock making a 52-week low could continue to make a new 52-week low with every passing week, unless there are valid reasons for it to bounce back.
Thus, choosing the exit is very important in contra picks as the journey is from despondency to exuberance—from being ignored to rediscovery. Defence and public sector banks could be prime examples from 2020 to 2023. Both these sectors underperformed, especially defence when the markets touched new highs post-COVID in 2021 but gave excellent returns when the markets turned range-bound. During the period of exuberance, the expectations shoot up, which is typically followed by disappointment, as sentiments are directly linked to expectations versus delivery.
The methodology would be slightly different when one is looking at value investing and vastly different when one is looking at momentum stocks or stocks/sectors, which are the flavour of the season.
The author is an eminent market analyst.