Investing in beaten-down sectors can help you profit from market downturn

Two fund houses—SBI Mutual Fund and DSP Investment Managers—recently opened their small-cap funds to lump-sum investments. In a recent interview to Business Standard, S Naren, executive director and chief investment officer, said that times like these are the best for investing in equities. “Currently, equity valuations are cheap and investor sentiment is that of panic. Historically, such times have proven to be attractive for long-term equity investing,” he said.     

With the major category indices (large to small-cap) down 26-31 per cent over the past month, equity investors are experiencing stomach-churning volatility. At the same time, India has gone from being a market commanding premium valuation to one where quality stocks are becoming available at attractive levels. Investors will be better able to take advantage of these conditions if they don the hat of a contrarian investor—someone who goes against the tide of popular sentiment. 

Increase equity allocation as valuations dip: One approach that can boost long-term profitability involves increasing equity allocation as the markets fall, and decreasing it as they rise, instead of adhering to a fixed allocation. Direct stock investors can use the 10-year band for price to earnings (P/E) ratio or price to book value (P/BV) to gauge where the market stands vis-à-vis historical valuations, and adjust their allocation (see table).

Those who find it difficult to implement this strategy on their own can opt for dynamic asset allocation or balanced advantage funds. “Balanced advantage funds can help investors take a counter-cyclical approach in these times when most investors tend to be pro-cyclical,” says Naren. These funds increase equity allocation when valuations fall and reduce it when they rise. “Such an approach ensures one buys low and sells high,” adds Naren. The equity allocation, which can range from 30-80 per cent, is model based to prevent behavioural biases. Those investing in the category should ensure the fund they select is indeed dynamically managed, that is, its equity allocation changes in response to valuations. ICICI Prudential Balanced Advantage Fund currently has a 73.7 per cent equity allocation. 

     

Hunt for value in beaten down sectors: The market downturn has thrown up attractive opportunities for contrarian investors. “If you wish to engage in contra investing, look for stocks that meet the following criteria: sustained price damage; institutional ownership that is lower compared to previous years; continuous negative news flow both for company and sector; and attractive absolute and relative valuations,” says S. Krishna Kumar, chief investment officer-equity, Sundaram Mutual. Kumar plans to add consumer discretionary sectors and financials to his portfolio over the long term as they are beginning to meet these criteria. 

The stocks contra investors buy should be able to survive the current turmoil. Says Nilesh D. Shetty, associate fund manager-equity, Quantum Mutual Fund: “The downturn has brought quality private-sector banks within our buy limit.” He suggests opting for private banks with enough capital adequacy to be able to withstand this period of pain, and those that have superior risk management capabilities. Krishnakumar suggests looking for players that have a good retail franchise and which stand to benefit from fee-based opportunities in asset management, wealth management, insurance, etc.    

Another sector within the consumer discretionary space where Shetty sees opportunity is automobiles, especially two-wheelers. Demand has been low within the auto sector due to economic weakness. Price hikes undertaken by companies due to the Bharat Stage (BS) VI transition could affect volumes. “But the sector remains attractive from a four-five-year perspective, given the current penetration levels. The two-wheeler industry will gain whenever the rural economy revives. And even if the environment worsens, these cash-rich companies will be able to sustain themselves,” says Shetty. 

Value funds may benefit from revival: The value fund category has been among the worst hit over the past month—it is down about 25 per cent on an average. Value fund managers back companies trading below long-term average valuations and accept depressed short-term profitability. Over time, as the economic cycle recovers, profitability improves. Value fund managers then get the benefit of both earnings growth and P/E re-rating. “Earnings have been depressed for the past several years. This year we were expecting to emerge from past disruptions, but got hit by the COVID-19 led global pandemic. It has postponed both economic and earnings recovery,” says Amit Ganatra, fund manager, Invesco Mutual Fund, who manages the Invesco India Contra Fund, which follows a value-contrarian strategy. Ganatra is optimistic that value-oriented funds will be among the biggest beneficiaries of a turnaround in the economy and earnings, whenever it happens. According to Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India: “Have a 10-15 per cent allocation to value funds in your equity portfolio with a five-year plus horizon.”

  

Time to build small-cap allocation: The number of quality stocks with adequate liquidity tends to be limited in the small-cap space. When the segment does well, it witnesses large inflows. Due to capacity constraint, many small-cap fund managers close their funds to lump sum investments. For instance, SBI Small-cap Fund had stopped investments in late 2015. It opened up for SIPs in mid-2018 because the Securities and Exchange Board of India’s (Sebi) categorisation norms defined capacity differently from the fund house’s norms, creating more room. But it did not open the fund to lump-sum investments then. “The fund had done very well. We did not want investors to invest or allocate more based on past performance. This turned out to be a good decision. After a frenzied 2017, the small-cap index posted negative returns in 2018 and 2019. And in 2020 it’s down 30 per cent till date due to the COVID crisis,” says R Srinivasan, head of equity, SBI Mutual Fund.

SBI and DSP Mutual Fund have both opened their small-cap funds to lump-sum investments recently. Says Srinivasan: "From a bottom-up perspective, several businesses with sustainable models are trading at attractive valuations." 

While opening up to lump sum investments should not be treated as a signal of an imminent revival in small caps, investors who don’t have an allocation to this category should start building it. “These funds can constitute 5-20 per cent of your equity portfolio, depending on your risk appetite. Enter with a seven-10-year horizon via the SIP route,” says Belapurkar.