Monthly Archives: June 2012

How to Think Like a Contrarian Investor

I speak Japanese.  Japanese was one of my majors at college.  To the average native English speaker, Japanese is a tough language, offering very little comfort and familiarity that might come with trying to learn Spanish, French or German.  In addition to three different writing systems to learn, the grammar and sentence structure of the language seem very foreign to most English speakers.  As a character in Shogun, James Clavell’s great novel about Japan, famously said, “The best way to learn Japanese is to stand on your head and think like a pretzel.”

Maybe learning Japanese has re-wired my brain, or perhaps I was born this way, but regardless, I am a contrarian investor.  That is to say, I generally lean against consensus thought and find my own personal comfort swimming against the tide.  Although some surveys suggest that a large majority of investors consider themselves contrarian, which is mathematically impossible (the majority opinion would be the consensus, duh), I think it much easier to consider yourself a contrarian investor than actually to be one.

Here’s an easy test of one’s contrarian investor credentials:  In March of 2009 were you 1) buying stocks, 2) selling stocks, 3) numb with fear?  If you chose number one, you are probably a contrarian investor.  If you chose 2 or 3, you are probably a well-adjusted, normal person.  At that time, the majority opinion was that this crisis is possibly the worst ever and selling risk assets and holding cash is the only prudent tactic.  I recall hearing some “guru” on the radio say that the stock market “may never recover from this crisis.”  To the contrarian investor, this kind of hyperbole is music to the ear.  Whenever any opinion becomes so widespread as to be assumed to be true (or even self-evident) by the vast majority of regular people, it’s time for the contrarian investor to start looking the other way.

As I thought about how best to explain contrarian investing, I decided to conduct a casual poll of my colleagues here at work.  Our firm provides tax services and wealth management/financial planning services.  Most of the people here are either tax specialists or investment specialists.  I asked everyone in the office yesterday one simple question: “In your opinion, what would be the worst way to invest your money right now?”  As I expected, the answers were divided clearly between the tax staff and the investment staff.

Everyone on the investment side had the same answer – “long-term bonds.”  Given that individual investors continue to stock up on bonds in record numbers (implying that the consensus opinion on bonds is bullish), this answer is highly contrarian, and probably right, in my view.

The people on the tax side offered a broader range of answers: Spain, Greece, bank stocks, real estate, commodities, gold, and so forth.  What do these things have in common?  They have been in the news lately and have been lousy investments either in the short term (gold, commodities) or for a long time (real estate).  To me, this suggests that these folks are “normal.” That is to say, they have a general idea of what’s working and what’s not, but they do not spend all day looking at the markets trying to assess what to do next.  That’s what I do all day.  Maybe I am “abnormal.”

But in a way, that’s the whole point of contrarian investing – going against the crowd, willing to be the lone voice in the wilderness.

As a contrarian investor, the list of my colleagues’ “worst investment” ideas may represent a “shopping list,” a place to consider for investing.  Just because an asset has performed poorly does not mean the contrarian investor will reflexively buy it.  U.S. real estate has been underperforming for five years.  Anyone who bought it four years ago (thinking it was a contrarian move) would have been proven wrong.  But looking for unloved and out of favor assets is a good starting point for the contrarian investor.

Being a contrarian investor does not assure success, it simply skews the odds a bit in one’s favor.  Assessing the consensus opinion and looking for some possible gems among the dirt of negativity is the job of the contrarian investor.  It can be at times messy, but the rewards are usually worth the effort.

More on Value Investing

I am a value investor.  Ever since my first reading of Security Analysis by Graham and Dodd in the early 1980s, I knew that this is how I would approach the investment business.  With much of the focus over the last four years or so on macro factors (economy, Europe, etc.), it is easy to forget that there are many very successful investment philosophies that nearly totally ignore many of these macro issues.  Value investing is one of them.

At its heart, value investing is simply buying things at a price much below what they are really worth.  If you know that bananas are fairly valued at $0.69 per pound, but you find bananas of equivalent quality on sale at Safeway for $0.49 per pound, what is your reaction?  Would you immediately assume (despite any supporting evidence) that they are “bad” and you should avoid them?  Of course not.  Most of us would buy some, thinking we had found a good deal.

Unlike most items sold at the store, we tend to not like stocks “on sale.” Most people too often associate a falling stock price with a failed stock.  Sometimes the stock is simply becoming less expensive, like the $0.49 bananas.

As simple as this approach may seem (simple, at least in my opinion), it seems quite difficult to implement in real life.  Most value investors are also contrarian investors who are comfortable riding at the periphery of mainstream.  Most people find comfort moving with the crowd. The contrarian investor loves to be moving the opposite direction from the crowd.

Lauren Templeton runs a hedge fund (details can be found here: http://www.laurentempletoninvestments.com/) and publishes very thoughtful essays about the investment business and capital markets.  In her latest piece, she explains the concept of value investing in a way as clear and comprehensive as anything I’ve ever seen.

Here are some excerpts from her piece:

“…we will be discussing one company but priced under two different market scenarios.  The company is well run, and has significant competitive advantages and growth potential over the coming decade.  The opportunities for the company are well understood by the market and the stock has historically traded at 18x earnings reflecting investors’ optimism.  In addition, after examining the firm’s probable growth in earnings and cash flows at 9%, one might determine that the current price at 18x earnings coincidentally approximates the intrinsic value of the firm, and for the purchaser at today’s price they might anticipate capturing the compounding of earnings over time at the estimated 9% clip, but not much else should be reasonably expected.  After purchasing the shares at intrinsic value, the company delivers on its long-term prospects, and the investor compounds their initial purchase at 9% thereby doubling their money in year 8.  [This is the rule of 72 for those wondering about the power of compounding].  The logic and outcome of purchase is respectable, and people can obviously do worse than compounding at 9%.”

What Lauren is describing here is someone buying a stock somewhere along the “Intrinsic Value” line seen in the graphic above.  This is like buying bananas at $0.69 per pound.

 

She continues:

 

“However, turning to the second scenario, the market is now in total disarray and pessimism has dragged down all share prices, even those of companies whose prospects are well understood and formerly prized.  In this case, the stock is now trading at 11.9x earnings, representing 50% upside to our original estimate of intrinsic value (at 18x), which has not changed in light of a small country in Europe not being able to pay its bills.  In this case, the purchaser at 11.9x earnings is still buying a company likely to compound its earnings and cash flows at 9%, but in the year after purchase a funny thing happens.  The market realizes it acted in haste and returns to the stock, driving its valuation back towards 17-18x earnings.  For this second investor, if they chose to hold over the same period as the first investor, they double their money in year 4 and rather than compound at 9%, over their 10-year holding, they compound at 13.6%.  As we can imagine, that additional 4.6% compounded over time can lead to a substantial difference in accumulated wealth at the end of the period.”

 

The second investor bought the stock when it was “undervalued” as shown in the graphic above.  This is what I try to do every day:  measure intrinsic value and buy stocks trading well below that level.  Simple to say, hard to do, but enormously rewarding when done right.  Hope this helps.

Stop Me If You’ve Heard This One Before…

I grew up in a storytelling family.   All my uncles, my dear Aunt Lilah, even my Mom were great storytellers.  They all had amazing tales about their exploits on the tough South Side (of Billings, Montana) during the Great Depression.  Most of the stories (which I’m sure grew in size and drama over the years, as all good stories should…), focused on fighting, playing in the park (or playing hooky) and trying to survive those hard times.  My Mom especially liked to tell us about all the boys, usually older and bigger than her, she could beat up!  Uncle Paul, the most successful business man in the family, began selling newspapers downtown when he was 8 years old.  Several of my uncles lied about their age so they could join the armed forces and fight in World War II.  My Aunt Lilah told hilarious stories about her time in Japan (she was a Sergeant Major in the Women’s Army Corps and was stationed in Japan during the Korea Conflict), often punctuated with machine-gun bursts of the few Japanese phrases she’d picked up there.  “Sore wa ikanai, dame, dame!”  Good times.

Some of these skills (storytelling, not fighting) have been passed down to me.  What is this blog, but me telling some stories?  Over most of my career I have been regarded as someone skilled in explaining complicated things in ways that anyone can understand.

In my view, a good story must contain at least these critical elements: 1) a clever title (I’m still working on this one!), 2) the “hook” – the opening that engages the audience, 3) the middle part where most of the action takes place, 4) the climax where everything comes together, and 5) the denouement, conclusion or wrap up.  I don’t always use all parts of this template in my work, but I think it would serve any storyteller pretty well.

Today we are hearing a “new” story about the capital markets and the economy.   The title is a something like “Balance Sheet Recession Ensures Slow Growth Going Forward” (from Seeking Alpha) or “U.S. Stocks Slip on European Debt Crisis” (from Market Watch).  The hook involves worries about Greece (or Spain or Italy depending on the day), fears of a China slowdown and/or weakening economic growth in the U.S.  A falling U.S. stock market is also a good hook for getting people’s attention.  The middle part of the story will feature lots of very smart people telling us what they think will happen.  Phrases like “this time is different,” “unprecedented developments” or “no easy answers” will be prominent features of the narrative.  Ultimately, only one of the many forecasted outcomes will occur, as is always the case.  In a similar vein, rarely does the most dramatic possibility happen, much to the chagrin of the most animated of the doom and gloom crowd.  The climax, if the story follows the pattern of recent years, will occur with the U.S. stock market correcting just enough (10%, 15%, 19%?) to scare enough people into thinking that the Mayans may be right about the end of the world happening soon.

The conclusion will likely be as it has been – the U.S. economy continues to grow at a modest pace; Europe is in recession, but will eventually come out of it; China may slow, but still grows at a global-leading pace and the U.S. stock bull market endures.  People may find the ending of the story a bit boring or even cliché, but I would submit that it’s likely to be a very happy ending.

I view the current weakness in U.S. stocks as a buying opportunity.  For investors already fully invested in stocks (congratulations!), it may be an excellent rebalancing opportunity.