Education

The contrarian approach to investing is perhaps as old as investing itself. In 1815, the British economist David Ricardo made a fortune buying British government bonds at deeply depressed prices, just before the Battle of Waterloo. What did Ricardo recognise that led him to assess this as a great investment opportunity? As Harvard economist Richard Zeckhauser put it:

“He was not a military analyst, and even if he were, he had no basis to compute the odds of Napoleon’s defeat or victory, or hard-to-identify ambiguous outcomes. Still, he knew that competition was thin, that the seller was eager, and that his windfall pounds should Napoleon lose would be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it.”

What is contrarian investing?

Contrarian investing means buying an investment when it’s undervalued in a less optimistic environment and then selling it when the situation has improved.

There are different levels of being contrarian. For example some investors may consider holding less or more of a particular stock relative to the market or their peer group to be contrarian, or to take one or two unusual investment positions. For us, being contrarian is much, much more.

We actively look to buy shares that others are selling and sell when others are buying. Why? Because if you buy and sell the same shares as other investors at the same time, by definition it is impossible for you to outperform that market. We are driven by performance and a desire to succeed. You need to have independent thinking. You shouldn’t just follow the herd.

You cannot do the same as everybody else and expect a better-than-average result.

Being a contrarian investor is much easier said than done

Going against the herd with every investment you make is extremely tough mentally.

By nature, people tend to conform. One of the ways people make decisions is to look at how others have behaved in situations, because copying others’ behaviour can be useful in many areas of life. For example, when choosing a restaurant online, using reviews from previous diners can be very useful. But it’s certainly not good to follow the herd when investing.

Why is this? As stocks become popular with investors, competition to buy increases and stocks can become overbought. The price is pushed higher, leaving you paying more, which detracts from the future return of that investment.

Stock markets are forward looking, meaning future expectations are already priced in. When a stock that is priced for perfection delivers results that are only ‘good’ the price could fall. But when a stock is priced for disaster and the outcome is only ‘quite bad’ the share price can rise considerably. Share price movement is driven by the difference between prior expectations for the business and actual outcomes.

Being contrarian improves your chance of paying a lower price and therefore achieving a better-than-average return. It also helps avoid speculative overoptimism, where prices rise too high, thereby increasing the risk of overpaying.

If you are willing to look in areas of the market that are unpopular with investors, you are more likely to find bargains. That is, stocks where excessive investor reaction has created the opportunity to buy at a good price.

But you cannot be contrarian for the sake of it and simply invest in any stock that has fallen. Many stocks that are at rock bottom are there for good reason. Some of these are beyond help, with little or no chance of recovery.

Trust yourself

‘Groupthink’ is just as prevalent in the investment industry as it is among personal investors. That’s why it’s vital to conduct your own research. Independent valuation discipline is critical, to help separate yourself from the competition and do things differently and consistently.

We never rely on external providers for research. In fact, we often view what the market is doing as a contrarian indicator (for example, if a sector is running hot and consensus is that it will continue to do well, we are more likely to avoid investing there).

How does contrarian investing work?

Successful contrarian investment requires a strategy and process that is repeatable and enduring.

To achieve a better-than-average result you have to do something different; you need to separate yourself from the pack. This starts with investing in areas of the market that others are ignoring, or have written off. Then we determine whether these companies are likely to exist in future, how they will provide a return on investment and what they are really worth. We approach this like a long-term business owner.

The diagram below describes our contrarian investment approach.

An investment in a stock starts with an assessment of a company’s true value, as indicated by the grey bar running through the chart. The red line shows the share price movement over time. We are looking to invest in shares when the price is well below our assessment of a company’s true value. This increases the likelihood that potential risks are already in the price. We believe this reduces future risk and increases future return potential.

We look to sell the stock when it reaches our assessment of its true value.

You will notice that we don’t attempt to buy at the absolute bottom then sell at the absolute top. Although this would be the ideal scenario to maximise gains, it is exceptionally difficult to predict the exact bottom or top of a share price cycle.

When we first start to buy a stock, the price can continue to fall. Remember we are buying at a time of negative sentiment and news often gets worse before it gets better. We see this as an opportunity. If the price continues to fall but our thesis remains intact, then this is a great chance to buy more of the stock at a lower price, therefore increasing our expected gain when the stock rises.

On the other side, when the price rises and gathers momentum it may run above our assessment of value. This is the ideal time for us to sell, as there are plenty of willing buyers in the market making it easy for us to dispose of the stock.

Emotions get in the way

Sounds easy, right? Simply buy when a stock has fallen and sell when the stock rises. In practice this can be extremely difficult.

The chart below shows the emotions you may feel as stock prices rise and fall. As stocks rise, optimism builds into excitement, then perhaps thrill and euphoria. Then a wobble happens, maybe the excitement just goes away, and that euphoria gives way to anxiety at first, then fear and then when the stock really falls, there’s a great deal of despair. Then the roller coaster starts again and you get relief, hope and optimism coming through again.

Source: Allan Gray

It’s completely normal to feel these emotions, but to turn this to your advantage you need to behave counterintuitively. As the chart suggests, we believe the point of maximum financial risk is actually that feeling of euphoria. That’s when the stock is priced for perfection, and that may well be the time to be worried about holding it. Conversely, the point of maximum financial opportunity, when the stock is priced to potentially rise the most, is exactly when you feel most despairing of the stock. These are the points we are continually looking for in stocks, the points of negative sentiment and maximum financial opportunity.

This is a stylised chart, but what does it look like in practice? Below is a chart for Newcrest Mining that illustrates contrarian investing. The black line shows the share price and the grey shaded area shows how our holdings changed over time. The emotions an investor may naturally feel are overlaid.

Our investment approach in practice

Source: Allan Gray Australia and Datastream, as at 30 September 2019.

The stock was riding high a few years ago, as Newcrest produced plenty of cash flow and profits. This is the point of euphoria and the share price reflects this. Then sentiment shifted to anxiety and fear. We started buying the stock when people were starting to give up on the company. The price continued to fall and we really increased our position when the consensus seemed to be despairing. It stayed like that for a while and we built a large position in the stock. Then as the outlook improved and people got excited about Newcrest’s prospects, hope and optimism returned and the price began to rise. Eventually the price reached a level where we felt it prudent to reduce our holding and reallocate those profits to other, more recently depressed areas.

It’s not all plain sailing

Things don’t always work out quite how we expected. Some stocks contrarians invest in can take much longer to come to fruition. We may invest too early and the stock continues to fall. Sometimes things get a lot worse before they get better.

Worley Parsons is an example of a company we bought into too early. In 2011 the share price peaked at over $31. We didn’t own the stock then; it was riding high as a result of the commodities boom. Then, over the next few years, the commodities boom gave way and the price continued to decline all the way through 2014. We made our first investment in the company in early 2015 at about $8 a share.

We thought we were getting a great deal, only to find that for a period of about six or seven months the price fell almost daily. This can cause you to test your thesis again and again. But we did and added to our position throughout that entire period. It took 13 months, however, from our initial purchase through to the share price trough.

In the fullness of time, the stock recovered and rewarded our patience. But that is why this investment approach can test our discipline and that of our investors. Sometimes we do get it wrong, but over the long term, we believe contrarian investing adds value.

Worley Parsons – sometimes it gets a lot worse before it gets better

Source: Allan Gray Australia and Datastream, as at 30 September 2019.

Where does a contrarian fund fit in a portfolio?

A genuine contrarian managed fund can provide a great alternative to ‘traditional’ Australian equity funds. The vast difference in approach – and investment holdings – can provide diversification for investors.

To illustrate our contrarian thinking, the chart below shows the average top ten holdings of the five largest Australian equity managers that describe themselves as active managers (those who actively manage an investment portfolio, as opposed to passive, index-tracking managers). It also compares these holdings with those in the ASX 300 Index as well as that of a contrarian manager. As you can see, the five largest Australian equity managers closely replicate the index, whereas the contrarian’s portfolio looks very different. It offers you another way to diversify your portfolio.

Source: Morningstar as at 30 November 2019.

A contrarian fund also provides exposure to stocks that are often written off by the market and therefore sometimes less researched. This can mean that a contrarian approach can offer exposure to stocks that the average individual may not hold, again providing diversification in a portfolio.

Contrarian investing – myths and reality

There are two common myths about contrarian investing. We dispel these below.

Myth 1 – contrarian investing is simply value investing

One of the things that people think about contrarian investors is that we are simply value investors. ‘Value’ stocks are often considered to be those with a low price to earnings (P/E) ratio. A P/E ratio measures a company’s current share price in relation to its earnings per share. It helps investors compare the relative value of different companies. A high P/E ratio could mean a stock is overvalued, or that investors are expecting higher growth rates in the future. Conversely, a low P/E ratio could mean the company is undervalued.

But a contrarian investor doesn’t always invest in companies with a low P/E ratio. In fact, we will sometimes invest in companies that appear to have a high P/E ratio, based on current earnings.

If we are value-conscious investors why would we do this? The reason is that the ‘E’ (earnings) may have collapsed in the short term. However, long-term, normalised earnings may be much higher than current depressed earnings. Therefore the normalised P/E ratio may actually be much lower. This highlights that simple point-in-time metrics are too often used in place of a detailed study of a company’s true earning capacity, through the cycle.

Myth 2 – contrarian investors need a catalyst

Another myth is that people often believe that we are waiting for a catalyst to trigger an earnings turnaround and a rise in the share price, but this is rarely the case. Much like economic (or even weather!) forecasting, catalysts are exceptionally difficult to predict.

The chart below describes why an earnings turnaround isn’t always necessary, the outcome only needs to be better (or less bad) than the market predicts.

The black line shows a company’s earnings over time. The market’s expectation is for much lower earnings in future, as shown by the grey dotted line, which is a terrible outcome for the company. As markets are forward looking, the share price has already reacted to the market’s expectations and dipped, as shown by the red line. The actual outcome is worse than today, but not as bad as the market expected. Earnings are only ‘bad’ rather than ‘terrible’, so the stock beats the market’s expectations and the share price rises. As investors in that stock we don’t need an earnings turnaround, the stock just needs to beat market expectations and we can do well.

We don’t require an earnings turnaround, we just need to beat expectations

Source: Allan Gray

Turning losers into winners – evidence for contrarian investing

The following study shows the potential advantage of buying at depressed prices.

We looked at the performance of the Australian market by sector, based on the ASX 300 Index from 2000 to 2019.

We formed loser and winner portfolios, consisting of the worst and best performing sectors and compared their performance after formation.

To qualify for the loser portfolio, a sector had to have featured as the worst performing sector during the previous five years. It also must have shown some persistence as a loser by way of being the worst performer for a minimum of 10% of the preceding five years. The winner portfolio was formed on the same basis, but using the best performing sectors.

Over the complete time period of 14+ years, we found that the loser portfolio materially outperformed both the winner portfolio and the ASX 300 Index. The winner portfolio underperformed both the loser portfolio and the ASX 300 Index.

Source: Morningstar, Allan Gray Australia, as at 30 June 2019

Source: Morningstar, Allan Gray Australia, as at 30 June 2019

The loser portfolio also outperformed a higher proportion of the time, and by a larger amount, in down markets than in up markets.

Source: Morningstar, Allan Gray Australia, as at 30 June 2019

Investment philosophy is not enough

Being contrarian requires more than just an investment philosophy. It needs to be in everything you do.

Going against human instinct and taking a contrarian approach to investing can be challenging. It takes practice, and commitment in your convictions.

The contrarian investment approach has outperformed the market over the long term, but it requires restraint and patience. It can mean periods of short‐term underperformance while we wait for the market to recognise the value we’ve identified in shares.

There aren’t many funds that invest this way, so our investments can look very different.

And it’s difficult being different! But for those who are willing to shun the herd, the rewards can be great.

Learn more about contrarian investing

To learn more about Allan Gray’s approach to contrarian investing and their flagship Australia Equity Fund you can watch our Fund in Focus video here, or fill out your details via the contact form below.