Going against the crowd

Contrarians, depending on their risk appetite, can enter aviation or maritime stocks

Stock prices are leading indicators. They bottom and start rising before the real economy does. Markets also peak earlier than the gross domestic product (GDP) growth rate. A recent example is India in 2008-09. The stock market peaked in January 2008 (last quarter 2007-08) but GDP growth declined only in the second half of 2008-09. Of course, different sectors led and lagged by different amounts. Auto stocks peaked before the Nifty. Real estate peaked after the Nifty.

The majority of investors, let's call them the crowd, places great weight on trend-following indicators, such as results. Most long-term investor will want to see a minimum of two or three quarters of earnings growth. Value investors also look for sound financial histories.

The logic is that genuine business trends last longer than two quarters. Hence, a conservative trend-following style works much of the time. Value investors try to reduce the risk and maximise the returns by only entering when discounts are low.

Contrarians carry the value-investor logic a step further and try to be consistently out of step with the crowd. While contrarians will study balance-sheets, they place more emphasis on behavioural factors in making investment decisions. If a stock is heavily touted, the contrarian assumes that it is fully-valued. If a business is known to be in trouble, the contrarian hopes that it has already been beaten down.

This approach carries more risks than standard trend-following approaches. A contrarian is betting that he or she can decode crowd behaviour well enough to enter at trend-reversal points when the crowd is wrong.

Contrarians tend to book profits too early when they exit investments. Contrarian logic can also be really risky when it's the basis for a short-selling strategy. The timing has to be perfect and the losses could be catastrophic while shorting.

Arguably there is some safety factor in following contrarian long strategies. A contrarian will enter only when a stock is unfashionable and hence, low-priced. However, the counter-argument is that stocks are often low priced for reasons such as inferior past records, and poor future prospects.

Despite those risks, contrarian plays seem to work best in highly cyclical but sound businesses where the contrarian may often manage entries near the very bottom. Which sectors would a contrarian invest in right now with say, a perspective of 18-24 months? Definitely not power, IT or telecom – these sectors seem to be in high fashion at the moment. Probably not real estate, media or pharmaceuticals either, after the recent price-bounces across those three sectors.

Automobiles are more promising from the contrarian viewpoint. The sector is seeing flat sales and a poor monsoon implies trucks and tractors will not do well in 2009-10. Fertilisers and pesticides will also not do well for the same reasons. Cement is another possibility because offtake could remain slow since it lags housing finance, and real estate.

Aviation is deep in the doldrums and apart from Jet, airport-construction and management businesses like GMR, and GVK would be struggling to meet projections. Shipping along with shipbuilding, ports, offshore logistics, and so on, has also been hit very hard so there could be plays there as well. Most engineering and construction firms will also struggle in 2009-10 because infrastructure project awards have slowed.

Now there is quite a lot of overlap in the contrarian and value investor matrices. For example, some auto companies will show profit growth in 2009-10 and so will some engineering, pharma, cement and fertilisers companies. These businesses have attractive price-book value ratios and value investors would also accumulate them.

The outright contrarian would look at aviation and shipping, shipyards, offshore logistics and ports because these sectors are showing fewer signs of turnarounds. There's less regulatory confusion, better track records and hence, less risk, in the maritime plays compared to aviation. The aviation situation could get worse before it gets better while maritime prospects may have hit rock-bottom.

Offshore logistics has received some investment already due to the promise of NELP awards and therefore, enhanced business prospects. However, conventional shipping, shipyards and ports are likely to have longer down-cycles. All three are driven by trade and heavily dependent on global economic conditions. The high-risk contrarian will pick aviation plays while the conservative contrarian will enter maritime stocks.