Strategies for Alpha Generation: Tapping into market inefficiencies and contrarian approaches

Authored by Gaurav Arora, Fund Manager and Principal Officer of Equirus Wealth Pvt Limited

There are usually 2 types of edges that an investor has – inefficiencies in the market and information advantage. With the same information being available widely to all market participants these days, the information advantage barely exists, if at all. Therefore, it’s the market inefficiencies that an investor has to take advantage of in pursuit of alpha. There are 2 types of inefficiencies that one can exploit – those in the valuation of undiscovered companies and those which occur due to behavioural reasons.

The equity markets, especially in an emerging economy like India alternate between periods of euphoria and pessimism. Pessimism is usually followed by a sharp correction in equity markets or extended periods of their sideways movement. It is in times like these that a thoughtful investor can take advantage of depressed security prices and generate superior returns. Such periods occurred in 2002-2003, early 2009, 2012-2013 and mid-late 2020 when quality companies were available at throwaway prices. In most other times, markets are usually “largely” efficient overall or in euphoria.

In times like these too, one can endeavour to find undiscovered companies or “hidden gems” which offer value and can lead to significant returns. These sorts of opportunities are much more prevalent in the mid and Small-Cap space of the market. However, in current times, mid and small-cap space itself is in quite a bit of favour and thus it is increasingly getting difficult to find these opportunities. In these circumstances, what does one do to generate alpha or superior risk-adjusted returns? One of the few edges that an investor has is behavioural or psychological especially as one looks for opportunities in the large or Mid-Cap space. Being contrarian where one has a conviction against the market is one such strategy.

A stock’s performance in the long term is invariably tied to its earnings growth. Other factors typically include the returns on capital that the business generates over its cost of capital, longevity and quality of earnings which is usually driven by the competitive advantage that the business enjoys and not the least, the starting initial price at which the business is bought. All these factors come into play while gauging how a company’s stock is likely to behave over a period of time. Encompassing all these is our investment philosophy which can be summarized as “Profitable Growth and Longevity at a reasonable Price”. There are various ways in which one can identify investments apart from looking at undiscovered names. Some of these are contrarian in nature.

1. Buying quality companies going through pain due to some temporary reason(s) – Most companies go through temporary periods of underperformance in business and in case the markets punish them for it, that is an astute investor’s dream time to buy. A company might be facing temporary high raw material prices which could be passed on with a lag and thus might lead to lower margins in the short to medium term. Markets sometimes tend to react negatively to quarter-on-quarter results and that gives an opportunity to invest in these businesses. The Russia-Ukraine war and general supply chain challenges resulted in a lot of volatility in several global commodities in the last 2-3 years and a lot of companies, even secular growth companies, faced temporary challenges.

2. Cyclical opportunities – Most businesses are cyclical, some more and some less. Highly cyclical businesses go through extreme volatility in their performance and consequently stock prices. Cyclicals can offer great opportunities to make great money over relatively shorter periods of time. If one can buy them when margins or low (or negative) and stock prices are low on current earnings/cash flows/EBITDA multiples, they offer opportunities for gains through earnings improvement as well as improvement in multiples. Auto and cement are some sectors that have such opportunities for investors in recent times.

3. High-quality compounders – The challenge here is starting valuations. However, a stock typically has a large trading range every year and if one can manage to buy a quality compounder when it’s sold off or when it’s had a long period of time correction, the returns can be disproportionate. These opportunities are lesser in number, especially in well-discovered markets but they do present themselves occasionally.

4. Value stocks – Typically there are cycles in which value and growth sections of the market outperform and vice versa. Also, in India, anecdotally, growth stocks tend to do better than value stocks (growth and value are mentioned in their traditional sense here). Value stocks, according to anecdotal evidence, tend to do well when the industry dynamics are changing. We saw that happen in industries like power (with thermal power making a bit of a comeback), cigarettes, public sector companies in general and banks in particular. How value vs growth does is also a function of the prevalent systemic interest rates which have been on the rise. As interest rates rise, far-off cash flows become less valuable implying that growth stocks tend to lose attractiveness vis-à-vis value stocks which have higher near-term cash flows. Identifying such shifts in sector attractiveness can lead to opportunities for returns.

5. Opportunity in change – A company that is going through or has gone through an important change can yield big returns. This change could be either a management change or a spinoff/M&A or new product/market/regulation etc. These opportunities keep coming regardless of markets and an astute investor can take good advantage of these.