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Reap rewards and diversify by going against the grain

Contrarian investing is simple in theory but investors must know how and when to use it in portfolios
May 16, 2019

Investors will know that the key to a healthy portfolio is diversification. A broad portfolio that combines different assets, geographies and investment styles provides the foundation for steady returns while helping weather different market environments. One way to diversify your portfolio is to allocate to contrarian investment funds, where fund managers go against mainstream market sentiment – in its simplest terms selling what others are buying and buying what others are selling.

The theory behind contrarian investing is that looking at parts of the market that are ignored and investing in stocks that are currently out of favour allows the investor to buy in at depressed prices. Thomas Rosser, investment analyst at The Share Centre, says stocks ripe for a contrarian investor’s attention often have fallen out of favour because an abundance of pessimism pushed the price of the stock below what it should be.

“The contrarian investor will seek to capitalise on this low price and buy before the broader sentiment rebounds and the share price increases,” he adds.

Contrarian investors believe companies can be wrongly valued because the market overreacts to both good and bad news, and these short-term movements in a company’s share price do not accurately reflect long-term potential. Buying a beaten-up stock can generate a significant return when such negativity lifts, according to Jason Hollands, managing director of Tilney. “This is providing the business is fundamentally not a broken one and there is innate, intrinsic value in it,” he adds.

Evidence shows contrarian investing has worked. Possibly the most famous contrarian investor is Warren Buffett, whose strategy of buying out-of-vogue companies has been a key factor in his success. In fact, his famous mantra of “be fearful when others are greedy, be greedy when others are fearful” epitomises contrarian investing. 

Over his long career, fund manager Neil Woodford has largely done well from contrarian investing despite poor recent performance. “He pretty much made his name by avoiding the tech bubble of the 1990s. He was one of the worst-performing fund managers and came under a lot of pressure to buy technology stocks, but he didn’t because at that stage of their development they didn’t have any cash or sales,” says Darius McDermott, managing director of fund rating agency FundCalibre.

“He was buying what would have seemed to have been boring tobacco stocks. At that time there was a lot of scrutiny of tobacco stocks because cigarettes kill.” But the contrarian investor take would have been that not all smokers would quit, and that they would be joined by new smokers in emerging markets being targeted by the tobacco companies. 

However, Mr Woodford’s recent litany of stock blow-ups are classic examples of when contrarian investing can go wrong. The main risk investors face is of falling into a value trap. This is when the market has actually priced the stock correctly, and the share price fails to recover as, for example, losses continue to mount and market share continues to be lost. Mr Woodford’s holdings in both Capita (CPI) and Provident Financial (PFG) resulted in a loss for the fund as the news flow got worse and the share prices tumbled.

“A low-quality business operating in a sector with poor prospects is not going to turn into a successful investment by default,” Mr Hollands explains. “Most contrarian managers will therefore also apply other criteria to their selection processes or overlay some quality criteria that might limit further downside.”

However, investing in contrarian investment funds or even sectors that are performing badly is not for the faint-hearted nor an investor expecting instant rewards. It can take time, often years, for unloved stocks to regain favour and contrarian investors need nerves of steel as there is no set deadline as to when the market will change its mind. “If an investor loses their nerve then they could end up selling a contrarian fund just at the worst possible moment,” says Adrian Lowcock, head of personal investing at brokerage Willis Owen. 

If you use a fund for contrarian exposure, there is also the risk that it can be difficult to discern whether a manager is failing or not as poor performance can be just a function of their strategy of backing out-of-favour businesses. 

 

Should you invest in contrarian funds?

“A contrarian would argue that investing by their method is a low-risk, high-reward strategy,” Mr Rosser says. “This is largely because of the idea that owning out-of-favour assets, with strong fundamentals, that trade below intrinsic value, permits a margin of safety.”

He recommends using the funds as part of a well-diversified portfolio seeking to make returns over a longer investment horizon of five years or more.

Mr Lowcock suggests putting no more than 10 per cent of your portfolio in any one fund and says no more than 25 per cent of an equity strategy should be allocated to contrarian investing, giving the opportunity to hold other styles such as growth and income.

Mr Hollands agrees, saying a portfolio needs to be a blend of styles because going too far with either contrarian funds or growth- driven funds is misguided. “Swings in performance can be significant and the great time might only make up for poor times over the longer run.” 

However, Mr McDermott cautions: “If something’s not worked for three years, stop and give it consideration. Although managers can be right about their predictions, they can be too early and so don’t make enough money.”

 

Fund performance

Fund/benchmark1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)
Man GLG Undervalued Assets-5.6142.1246.740.9
Jupiter UK Special Situations-6.1831.9933.010.76
Fidelity Special Situations-6.230.2941.40.91
FTSE All-Share index-2.7131.3230.91 
Investment Association UK All Companies sector-2.9228.0830.45 
RWC Global Horizon3.6253.52 1.15
MSCI All Country World index3.9350.275.88 
Investment Association Global sector4.1746.2764.1 

Source: FE Analytics, as at 10/05/19