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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. 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.
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 red line shows the share price movement over time. This increases the likelihood that potential risks are already in the price. We believe this reduces future risk and increases future return potential. 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. 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 the roller coaster starts again and you get relief, hope and optimism coming through again. As the chart suggests, we believe the point of maximum financial risk is actually that feeling of euphoria. 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. 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. 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. 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. Then, over the next few years, the commodities boom gave way and the price continued to decline all the way through 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.
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 Index as well as that of a contrarian manager.
It offers you another way to diversify your portfolio. 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.
One of the things that people think about contrarian investors is that we are simply value investors. It helps investors compare the relative value of different companies. If we are value-conscious investors why would we do this? However, long-term, normalised earnings may be much higher than current depressed earnings. As such, contrarian investing is often counter-intuitive in nature. The recent fashion in equity markets has been towards a momentum style, driven by passive investment flows.
Markets have enjoyed an upward trajectory since their low point in thanks in the main to the availability of cheap money and low returns for savers elsewhere. Cost effective passive or index tracking strategies have been popular while active investing has been roundly criticised for some time. With career security in mind, professional active managers have faced a disincentive to stray too far from their benchmarks - the result quite often being index-like returns at a considerably higher cost than passive funds can offer.
Pressure to perform often leads to short-termism and the compulsion to act rather than wait for a thesis to play out. A contrarian approach, however, is a highly active and differentiated investment style that seeks to provide above average returns over the longer term by employing the opposite approach used in passive investing. It enjoys the advantage of being active, but is not measured in tracking errors or overweight and underweight allocations. It allows the freedom to look closely at those stocks that the rest of the market is ignoring.
This seems, on the face of it, to be a simple enough directive however it is, in-fact, extremely hard to do. For the majority, this is also where financial losses can result. It is exceptionally difficult to perfect the timing of purchases and sales. A contrarian strategy attempts to avoid the overblown trades prevalent during pricing bubbles, caused by the indiscriminate crowding of capital.