Contrarian investing is a time-tested investment tool, which involves buying/selling stocks that go against the prevailing sentiment of the crowd or the market. It is among the first lessons taught to budding investors and literature on the subject dates back decades. We have covered two major themes based on consensus ratings (stock popularity) and valuation multiples, and have demonstrated the success of contrarian investing in India. Bloomberg collects analyst recommendations on each stock and assigns a consensus rating based on these recommendations. It assigns five points for every buy recommendation, three points for every hold recommendation and one point for every sell recommendation. A consensus rating is arrived at by taking the average of these scores.
Our analysis based on empirical evidence over the last decade suggests that investing in out-of-favour stocks can generate disproportionate returns as compared to the market. Our findings suggest that neutral to moderately popular stocks deliver significant outperformance, even bettering the most popular stocks. Our findings are in harmony with the findings of ‘Analyzing the analysts: When do recommendations add value?’ by Narasimhan Jegadeesh, Joonghyuk Kim et all, that in the absence of favourable characteristics (value stocks and positive momentum stocks), the most popular stocks are associated with the worst returns. Our findings prove that out-of-favour low P/E stocks deliver disproportionate returns, significantly beating the benchmark. In contrast, the performance of high P/E stocks is dismal.
From net sell to net buy
Our findings suggest that a simple strategy of investing in stocks for which analyst consensus has changed from “net sell to net buy” with a holding period of one year has delivered 24.1% annual returns over the last 10 years. In the study, Analyzing the analysts: When do recommendations add value?, the authors also find that the quarterly “change” in consensus recommendations is a robust return predictor that appears to contain information not contained in a large range of other predictive variables.
Besides the superiority of neutral to moderately-popular stocks, we have established that the most popular (Q1) and second-most popular (Q2) stocks also beat the benchmark. (As a part of our analysis, we have divided BSE 100 in five groups of 20 – Quintile-1 (Q1), Quintile-2 (Q2), Quintile-3 (Q3), Quintile-4 (Q4) and Quintile-5 (Q5), respectively, with Q1 being composed of the most popular stocks and so on.)
Predicting the winners
The result seems fit, as popularity is an aggregate measure of sell, buy and hold recommendations, and conveys more information than selling/buy recommendations in isolation. Consensus sell recommendations, with their scarcity value, are better predictors of stock performance than buy recommendations. Our findings suggest that trailing valuation multiples are much better predictors of future performance as compared to forward multiples. Our findings also suggest that the price-to-earnings (P/E) multiple is a better predictor of returns, outperforming price-to-book (P/B), significantly.
Pharma ripe for contrarian investing
The application of our framework on sectors suggests that opportunity for contrarian investing is best in the pharma sector. We have also back-tested the thesis on the metals sector based on numbers for FY16, when the sector checked all the boxes for contrarian investing. However, we still do not believe that the IT sector qualifies for contrarian investing yet.
The writer Gautam Duggad is head, Institutional Research, Motilal Oswal Securities