by Guy W Pope, Threadneedle Investments
A unique approach to contrarian investing
There is no set definition of the term “contrarian investing”. Some investors look at themes or sectors that are out of favour, or search for “deep value” by using traditional financial metrics, buying into companies whose share prices have fallen to a steep discount relative to the value of their assets or earnings, but which hold the potential to rebound. The share price of the company may have collapsed, usually as a result of a shock event or a decline in profits, to the extent that the stock market is not convinced that the company can survive.
The deep value approach has proved popular in the US but clearly there are risks. The company may, for example, go bankrupt, while even when a lowly-valued company survives, its share price may not recover.
However, themes and sectors can stay out of favour for long periods of time, and financial metrics can be subject to accounting policies and creative bookkeeping. Our experience shows that overly pessimistic outlooks for companies create the best investing opportunities, and that low stock prices are the best indicator of such pessimism.
As Warren Buffett has pointed out, “The most common cause of low prices is pessimism — sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
Value and growth stocks
We believe that out-of-favour stocks can fall into both the value and growth camps and that they can be initially identified by a price screen. Deploying such a tool can help to pinpoint inflection points in economic cycles or a company’s product cycle in advance of it occurring.
We use a “contrarian” screen, which identifies stocks that are trading in the bottom third of their 52-week price range. Price is thus used to measure pessimism in the marketplace.
It is then vital to distinguish those stocks that are languishing for fundamental reasons, such as because their business model is no longer working, and those that are depressed because of a transitional headwind. In the latter case, companies which have strong management and good products can overcome any temporary difficulties and their stock price will hold considerable upside potential. To quote Warren Buffett again: “I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.”
Further fundamental analysis of a company is necessary before the decision of whether or not to buy the stock can be taken. This may involve some form of discounted cash flow analysis but the exact methodology will vary depending upon the industry or sector in which a business is operating. It is also important to analyse the industry or sector in detail. Are there any trends that could support the company or alternatively could pose a significant threat? Talking to company management and the investor relations team will also prove critical in determining whether a business is worth investing in or not.
Having a sell discipline is important in contrarian investing. If a stock underperforms the benchmark by a specified amount, for example, it might be a good idea to review the stock to determine whether the thesis that prompted you to buy it remains valid. Such a rule can also help investors to recognize whether better ideas exist.
Investing in all conditions
Contrarian investing can help in a variety of market conditions. Consider some examples from the past few years. During 2006 and 2007 mid-cap and value-oriented stocks performed best, having languished in the preceding period. However, in the 2008 bear market, large-cap and more growth-oriented stocks did better on a relative basis having lagged the market in 2006 and 2007. The stocks that got hit the hardest during the downturn were often the ones to rake in the highest returns in 2009. But the key to outperformance in each of these very different market environments involved good stock selection rather than simply buying any stock that happened to be cheap.
In other words, price screening allied to fundamental analysis, which separated companies that deserved to see their share price punished from good companies hit by temporary adversity, underpinned good performance.
Think of the following typical investor experience. The investor buys into a stock at, for example, US$30. Following a strong quarter and the release of an optimistic outlook by company management, the stock price rises to US$40 when the investor, pleased with the stock, increases his stake. The price then rises to around US$45 when it is hit by a seemingly adverse development. This could involve missing an earnings target or failing to maintain meteoric earnings growth. The stock price subsequently falls back to the US$30 level where it was first acquired and the investor begins questioning what prompted him to buy the stock in the first place. Following another moderate quarter, the stock price slips again to US$25 or US$20 and the investor sells it out of desperation. At this level it shows up on our price screen for analysis.
Exxon Mobil is an example of a stock that has followed this cycle in recent years. It underperformed the market for 18 months almost in a straight line in 2007 and 2008. In the preceding years the stock had risen sharply. The last leg of underperformance was driven by investor disappointment regarding an acquisition, and investors’ preference for small and mid-cap companies. Finally, the stock was removed from the Russell 1000 Value Index and replaced in the Russell 1000 Growth Index. Index rebalancing created a mismatch between buyers and sellers: Index-focused value investors would be quick to sell the underperforming holding. Meanwhile, growth investors would think that the business did not meet their criteria for a “growth stock”. The stock hit the price screen as a result of this short-term “pessimism” and subsequently rebounded.
To sum up, it is well-known that stocks and sectors that underperform in one period can rebound sharply. However, screening stocks and adopting a sell discipline is necessary if an investor is to reap the full rewards that contrarian investing can offer. In particular, it is vital to separate the stocks that are depressed for a good reason from those that are genuinely undervalued.