The case for contrarian value investing
Last week I attended the 69th Annual CFA Institute Conference. It was a whirlwind event chocked full of excellent presentations ranging from Fintech to mindfulness. I usually come away with pages upon pages of notes and material to look at further and this year was no exception. One of the speakers on the first day was Rupal Bhansali who spoke on contrarian value investing. Her speech offered some valuable advice for all investors and some thinking on being a contrarian.
In the last few years there has been a bit of a popularity surge in people claiming to be contrarian investors. Likely due, in no small part, from our more recent understanding of behavioural finance biases in investing. Everyone likes to think they are greedy when all are fearful and fearful when everyone seems greedy, but I fear most people are just trying to be anti-consensus for the sake of being thought of as contrarian. The problem with this, is that the crowd is often right. Sometimes asset classes, stocks or markets are down or up for very good reasons and there is no real basis for why it should be different.
Here are some of my thoughts on the presentation and what I have found over the years:
1. Measures of volatility are not risk.
With the finance professions insensate focus on measuring everything it may have gone a bit too far. Risk measurement is not the same thing as risk management. We spend a great deal on quantitative risk models and volatility-based ratios under the assumption that adding Greek letters in a formula will be able to alert us to elevated risk in portfolios. There's nothing wrong with quantitative models. They can be helpful when they're used correctly, but they are not the be-all, end-all of risk management. They are tools, not plans. Measures such as standard deviation or beta do a poor job measuring this. It is more important to look at what you're getting, not necessarily what the stock price has done. Volatility is an opportunity for the long-term investor and the enemy of the short-term investor. Risk to me is the permanent impairment of capital or the probability that you won't meet your financial goals.
2. Screen out risk first, then consider value.
Ignoring risk is a common error I have seen when running investment screens is done solely on value parameters. If you follow these parameters blindly then you end up picking up a lot of junk. Cheap valuations do a wonderful job of distracting you from quality. It is very important to pay attention to what you are getting, not just what you are paying. Loading up on “optically” cheap investments is a poor strategy. As I mentioned before, sometimes things are cheap for a reason. Bhansali's approach is one I agree with. The key is to screen out risk first then focus on value. You want to eliminate low quality businesses with weak balance sheets and remove companies that could be value traps and/or blow ups. You are punished harshly for getting this wrong and this strategy requires you to have a penultimate focus on avoiding the losers rather than picking winners. If an investment opportunity offers too much risk and uncertainty, regardless of price, it is often best to walk away.
3. Patience is key.
With most forms of value investing, patience is a key criteria. Timing most contrarian value opportunities is very difficult. Sentiment tends to hit extremes before reversal even begin to gain traction. Emotions can cause prices to detach from fundamentals in a hurry and stay that way for a very long time. The process is often lonely and painful at times. It's easy to find things that are down in price but much more difficult to know if or when they will turn around.
Trends can last much longer — in both directions — than most investors assume is possible. Bhansali offered an interesting analogy when describing this process. Contrarian value investing serves fine dining not fast food. Fast food tastes great right away and is cooked fast. Think of these strategies as a form of trend following or momentum investing. Contrarian value food takes time to prepare. You will get excellent quality food but you will need to wait a bit longer for it.
4. Denial is deadly.
Not all individual stocks come back from the dead. Markets or asset classes don't go to zero but individual companies certainly can. Disruptive forces can change markets and prospects immensely. Blue chips of yesterday do not typically remain the blue chips of today. That is why simple reversion to the mean strategies can be insipid. Hope is not a strategy. Avoid anchoring to past price points or levels. Stocks don't have to trade back up to their previous highs just because they were there before. That past price level is meaningless if the fundamentals of the company have changed. If the fundamental aspects have changed you are not being contrarian if you deny this. You're just ignoring reality. It's important to be intellectually honest about circumstances and not just nescient of the situation.
In investing, as with most things in life, there are many ways to get things done. Contrarian investing is one of the harder roads to follow as it tests our ability to remain independent and outside of convention. Because it is so difficult to consistently remain patient and lonely, it is probably why it will always be a successful strategy overtime.
Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and can be reached at email@example.com. Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.