Why standing apart stands out
Value investing and contrarian investing are intrinsically related. Value investing seeks to identify good quality companies that are trading cheaply. To achieve that goal, contrarian investors tend to look in places that others have not. In doing so, they hope to uncover opportunities that are cheap relative to their intrinsic worth.
Both sets of investors must first establish what they believe a business is worth before betting against the market. There are few things as rewarding for either a value investor or a contrarian investor (many of which are one and the same person) than identifying a dislocation and mispricing in the market, supported by a consensus view, and investing with success despite the wider community’s concerns.
It is worth noting that there is a subset of contrarian investors who do not undertake fundamental analysis of a business before they buy. This investor is keen to speculate (often successfully) that the market is wrong simply because ‘everyone’ is on the same side. There is some merit to this argument, as we’ll discuss shortly, but it is worth noting that this approach is about ‘speculation’ rather than ‘investing’.
It’s also worth noting that sometimes companies are cheap for a reason. Some businesses are unloved because they are undeserving of anything more.
The ideal circumstance for us is to be able to identify an out of favour business and identify why the market does not like it.
By understanding why others don’t like a business, we are able to assess the matter and decide for ourselves if that reason is justified. Sometimes it turns out that consensus concerns are justified, yet often enough the mispricing is being driven by sentiment or emotion.
If we can get comfortable investing in uncomfortable ideas there is plenty of opportunities to outperform.
Despite the emotional difficulty many investors face when considering an idea that is unpopular, for investors able to consider the matter objectively, it is self-evident.
Take for example a function room filled with 99 people and our hero Joe buying and selling items.
Each time an item is bought, the price is increased by 10%. Every time one of those investors decides to return the item, the price is decreased by 10%.
As the night progresses it becomes apparent that one item (though not materially different to any of the others) stands out. So much so that by the time Joe has been made aware of it, every other person in the room has bought one.
Is it likely that purchasing the popular item as buyer number 100 is still a good idea?
Possibly, but it’s unlikely, and certainly objectively it’s not as good an idea for buyer 100 as it was for buyer number one.
Outside of the context of investing, this concept is easy to understand and makes an abundance of sense. Yet for some reason, when it comes to investing investors tend to crave the approval of the crowd.
Human nature is such that inexplicitly most people would feel more comfortable being investor #99 than being investor #1.
A Collins St Value Fund case study
In 2017, with no fanfare and just a little trepidation, we made our first investment into ASX listed uranium companies.
Uranium at the time was an extremely unloved sector. It was seen as culturally unacceptable, dangerous, and dirty. The ‘recent’ disaster in Fukushima and the HBO mini-series Chernobyl did the sector no favours as well.
Yet we recognised that there was a significant dislocation between what markets were willing to pay for yellowcake (the input into nuclear power station uranium rods) and the cost of producing it.
The dislocation was so severe that the two major global producers cut their production by 20%.
Still, markets did not move. It seemed that investors were convinced that the sector that sustained 11% of the global electrical grid would be maintained indefinitely, despite the producers (of the raw material) losing money every day.
We recognised the fantasy in that outlook and became increasingly confident in the idea.
To us, the fundamental drivers looked strong.
Demand was steadily growing and supply was steadily falling. The USA announced that they were going to indefinitely delay the decommissioning of some of their older power stations, while China, Canada, India and Russia announced a steady
increase in power plant builds.
The facts were that demand was increasing and that spot prices for uranium either had to increase or the world needed to get comfortable giving up 11% of its electricity usage.
Facts don't care about your feelings
There was a distinct dislocation between the way people felt about the asset and the intrinsic value of that asset. Between those two points lay a tremendous amount of opportunity.
What came next:
What came next was a powerful lesson in the value of conviction and patience.
While the underlying spot price of Uranium improved gradually, over the next couple of years the equities related to Uranium continued to underperform. As they underperformed the Fund increasingly grew its stake in them.
For 3 years, we waited, and for 3 years share prices did nothing but disappoint.
Our patience and conviction were rewarded. As an illustration, having gradually brought our average cost in PDN down to 11c per share, late 2020 saw what can only be described as a massive catch up for uranium equities.
In the blink of an eye, the conversation about the sector shifted from the culturally unacceptable to a cultural necessity. Uranium, which has often been thought of as scary was suddenly recognised as the only ESG option for baseload zero-carbon energy.
The USA implemented government buying programs (to ensure stability in the energy sector), and funds started looking for investments. As a result, ETF’s were launched and before we knew it, producers and investors were competing for yellowcake in a rapidly shrinking spot market.
Share prices reacted accordingly:
Across our portfolio of Uranium companies, we saw significant price increases. So much so that the team decided to substantially trim our exposure. After all, having not seen any rewards for our efforts for 3 years, the sudden rally over 6 months (from November 2020) saw our Fund generate a 47% compound annualised return - a wonderful outcome.
The very premise of value and contrarian investing is that unloved and under-appreciated companies with sound fundamentals will inevitably be recognised for the value they inherently possess. Companies that were once contrarian will eventually become mainstream.
Once that happens, fundamental investors of all sorts will need to carefully assess if there remains value in those spaces or if the crowd has pushed prices beyond reasonable levels, and like poor Joe, at his auction event, there is no value left.
To find out more on our firm's philosophy, performance history and current sector positioning, watch the CSVF Fund in Focus here.
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Michael is the MD and one of the founding partners of the Collins St Value Fund. The Collins St Value Fund is one of the best performing Funds in Australia - having ranked among the top 10 performing funds across all Australian Equity mandates by...