Value and contra funds have some similarities in their investment approach, but the two styles also differ in what they are actually betting on. When deciding which one to choose, investors need to understand how these approaches stack up against each other.
"All value is contrarian. Not all contrarian investing is value," says Sirshendu Basu, head of product management and strategy at Bandhan AMC.
“Value investing focuses on identifying businesses that appear mispriced relative to their fundamentals, while contra investing seeks opportunities where market pessimism may have created a disconnect between current sentiment and the underlying long-term potential of a business.”
In practice, value investing starts with earnings, book value and cash flow, looking for a price below a defensible estimate of worth. Contra investing starts with the trigger instead—usually a cyclical downturn, a controversy or a technology scare—and takes the view that the worst is behind the company and the market has misjudged what comes next.
What price says
The two approaches therefore read a balance sheet differently.
For value investors, financials help estimate what a business is worth: what a company owns and earns is the raw material for that calculation. For contra investors, the balance sheet is also a survivability test—a check on whether the business can withstand its current troubles and last long enough for sentiment to turn.
That is why value tends to favour companies whose worth is already visible in their financials, while contra opportunities, as Basu puts it, lie "not only in cheap stocks, but also in high quality, growth businesses, sectors, or themes that are temporarily out of favour."
Different catalysts
The two styles also differ in what has to happen for an investment to work.
Value investing waits for the market to recognise the worth already reflected in the financials. The wait can be long, but the value being waited for is expected to exist.
"In a value fund you hope the market recognises it at some point," says Ravi Kumar TV, co-founder of Gaining Ground Investment Services.
In contra investing, however, the thesis depends more directly on a change in sentiment or a recovery in the underlying business. The investor is betting that the market's current pessimism is excessive and that the situation will eventually improve.
The risks follow from these differences.
“In value style, the risk can be stock may be a value trap. On the other hand, in a contra style, sometimes the market consensus may actually be right,” Kumar said.
For a value investor, therefore, the key danger is paying a low price for a business whose fundamentals are permanently impaired. A contra investor faces a different risk: the market may not be wrong about the company's prospects, and the expected turnaround may never happen.
Similar portfolios
Both approaches typically pick stocks from the bottom up rather than simply mirroring an index. Both can also lag in bull markets led by growth and momentum, which means either style can provide diversification for a portfolio already tilted towards momentum or growth.
Yet their portfolios can still look similar.
The same stock can sit in a value fund and a contra fund at the same time, but be held for different reasons. One manager may have bought it because its valuation looks compelling, while another may be betting that a change in sentiment will unlock its long-term potential.
Investors must remember that these are both style-oriented funds and should not be considered for the core portfolio. Instead, investors may look at such funds for the satellite part of their portfolio, where they can complement more diversified core holdings. Investors should also avoid new fund offers and allow such funds to build a track record before considering them. Remember, just like all equity funds, these also need longer investment horizons.