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How to be a contrarian investor

Standing out from the crowd could boost your returns if you avoid the pitfalls of contrarian investing
December 28, 2017

There are several different ways you can apply a contrarian approach to investing, such as buying companies in out-of-favour sectors that other investors are avoiding. But if you are going to apply this approach to investing in equities you will need to make decisions that are eventually embraced by the crowd – otherwise the price of your shares won’t rise.

Stephen Anness and Andy Hall, managers of Invesco Perpetual Global Opportunities Fund (GB00BJ04HD64), explain: “At its most basic, contrarian investment involves buying when others are selling, but true contrarianism is about redefining the consensus rather than unrelentingly opposing it. We want to be proved right, which means our decisions must stem from something disciplined and rigorous, rather than from an unfocused desire to contradict for the sheer devilment of it.”

Out of favour sectors are often areas that have recently underperformed other parts of the market. “In 2017 the areas that did well included US tech stocks such as the FAANGs – Facebook (US:FB), Amazon (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX) and Google, known as Alphabet (US:GOOGL) –  and their equivalents in China, such as Tencent (HKG:700),” says Ben Yearsley, director at Shore Financial Planning. “The areas that underperformed included healthcare, UK domestics and banks. UK domestic stocks have been weighed down by worries about Brexit, interest rates rising and stagnating wages, so there are good short-term reasons why they have had a tough year.”

The UK’s uncertain economic picture could present an opportunity to pick up cheap stocks in an unloved area. Investors looking to take advantage of this include James Lowen, co-manager of JOHCM UK Equity Income (GB00B95FCK64).

“[Mr Lowen] thinks the UK market is the most exciting he’s ever seen it because of the massive discrepancy between UK domestic stocks, which are trading on price-earnings ratios of around 10 times, and international stocks on 20 to 25 times earnings,” says Mr Yearsley. “He holds stocks such as Kingfisher (KGF), Lloyds Banking (LLOY) and Aviva (AV.) that are, in his opinion, unnecessarily cheap.”

Buying the cheapest stocks in the market is a contrarian approach that has similarities with value investing. Value investors buy stocks that are cheap relative to their fundamental value, measured in terms of earnings, dividends, sales or net assets. Mr Hall and Mr Anness are both fans of this approach.

“The best businesses on earth can still be a bad investment if their shares are bought at the wrong price,” they say. “Equally, a ‘bad’ business can become a good investment if, in keeping with our contrarian philosophy, its shares are bought at a price that is sufficiently low.”

Buying cheap stocks could mean investors make money if there is a recovery in their share price, and it can minimise risk.

“Nobody wanted utilities during the dot-com boom because the thinking was what’s the point of having a utility when everyone is going to be using the internet?” says Adrian Lowcock, investment director at Architas. “But that made them good contrarian plays. These were stocks that were yielding 10 per cent and growing dividends, which is not to be sniffed at. That contrarian play also allowed you to avoid the overvalued, expensive part of the market.”

But although contrarian investing is often associated with value investing you can also take a contrarian approach while investing in growth stocks. James Yardley, senior research analyst at Chelsea Financial Services, says: “Amazon is a good example of a growth stock that could be considered contrarian, as a lot of people are sceptical due to its high valuation and unsure whether it can continue its disruptive growth. You could argue that the whole tech space is a contrarian bet as a lot of investors are sceptical that it can keep going up. Yes, those stocks are expensive, but maybe they’re not that expensive [compared with what they can potentially rise to].”

Another contrarian approach is to anticipate and exploit investors’ cognitive biases. Chris Dillow, Investors Chronicle’s economist, thinks this can be very effective. “There are two ways stocks are often mispriced,” he says. “Investors tend to overvalue growth prospects and seek growth where it isn’t, which means they also undervalue really dull companies or those that have strong competitive advantages. The other reason for mispricing is because investors tend to underreact to good and bad news on a company, which is what leads to momentum in the market. If you believe a stock is a good company and it gets some bad news, then you might brush off that bad news. As a result, the share price doesn’t tend to move very much on that bad news. It is possible to be a contrarian and momentum investor at the same time by, for example, immediately selling on bad news, which allows you to get out of a stock [that is starting to experience negative momentum] before other investors have reacted.”

And as momentum in the market works both on the upside and downside, a contrarian investor can benefit from positive momentum by immediately buying into a company that has received good news.

Considerable contrarian risks

There are also considerable risks to taking a contrarian approach. The consensus view might be correct, and even if it is ultimately wrong markets can be irrational about a stock or sector for a very long time. “You may have thought Bitcoin was overpriced at $5,000 (£3,738.6), but it has since trebled,” says Mr Dillow. “Likewise, the S&P 500 cyclically adjusted price-earnings (CAPE) ratio was far above its long-term average three or four years ago, and it’s doubled since then. So, even if you think the markets are being stupid, they can be even more stupid.”

Professor Raghavendra Rau of the Cambridge Judge Business School, adds: “Plenty of celebrated investors, including George Soros and Julian Robertson, have suffered from being contrarian investors who questioned the value of rising bull markets and avoided participation in glamour stocks for years. Mr Robertson actually closed his Tiger fund early in 2000, after consistently avoiding the mania for tech stocks throughout the 1990s, before markets turned in his favour.”

Another risk of value and contrarian-style investing is value traps – stocks that look attractive because they are cheap but never recover their share price. Fundamentally, they are cheap for a very good reason.

“Investors need to understand whether something is good value, or cheap because it’s in terminal decline for a structural reason rather than cyclical reason,” says Mr Yearsley. “Buying Kodak in the mid-1990s, for example, would have been absolutely the wrong thing to buy as it was in terminal decline. You might have thought ‘this company has been around for 100 years, it’s got a good brand and looks cheap now but will recover’. However, that sector is all but gone because with mobile phones and tablets people don’t buy cameras in the same way.”

The sectors he thinks look vulnerable on structural grounds today are those under pressure from digital disruption, such as high-street retailers and traditional media organisations such as ITV (ITV). UK utilities also look cheap, but could be negatively affected if a Labour government comes to power as the party has talked of nationalising them. 

Some of thesectors that are currently unloved, meanwhile, such as miners, oil and gas companies, banks and supermarkets, could be particularly vulnerable to an economic downturn as they are generally more economically sensitive.

There are also practical problems with implementing a contrarian strategy. Ideally, your portfolio should be well diversified across sectors and geographies to protect against the risk of one area performing particularly badly. But as a contrarian investor you may be more likely to hold stocks in unloved parts of the market, so it could be more difficult to have a well-diversified portfolio

And if you want to quickly take advantage of stocks you believe the market is incorrectly pricing, you will probably need to trade in and out of positions, which can rack up dealing costs and tax liabilities. This could eat into your returns.

“Although being contrarian sounds simple, it is very difficult to execute as you need to have the knowledge and expertise to know whether something is a value trap, recognise you will never get every investment right, have huge amounts of patience and the self-belief to hold on to your convictions, and also know the difference between confidence and arrogance,” says Mr Lowcock. “It’s a fascinating and profitable way to invest, but it can be very uncomfortable.”

But if you feel comfortable with these requirements and are able to invest for at least 10 years, you could certainly consider contrarian investing.

Funds that take a contrarian approach

If you like the idea of taking a contrarian approach but do not have the time or knowledge to choose your own stocks, you could invest in a fund whose manager invests via a contrarian style.

Ardevora UK Equity's (IE00B3WN9227) manager, Jeremy Lang, looks to cognitive psychology when choosing his contrarian positions. “This is a high-conviction fund able to profit from selling shares as well as buying them,” says Mr Lowcock. “Jeremy Lang picks stocks based on his behavioural analysis, and by identifying bias among company managers, analysts and investors. These biases can lead to the market making wrong decisions on the value of a business and enable Mr Lang to take the contrarian stance.”

Old Mutual UK Alpha (GB00B8XY5K91), run by Richard Buxton, takes positions in unloved sectors.

“Richard Buxton is a traditional contrarian investor who buys unloved stocks and waits for the market to change its view,” says Mr Lowcock. “He builds a concentrated portfolio and takes high-conviction positions in sectors that are undergoing structural change. Mr Buxton takes aggressive positions in the portfolio and uses his macro outlook to lead investment ideas. The fund currently has around 12 per cent of its assets in banks and 10 per cent in oil and gas.”

Another well-known fund manager who typically takes a contrarian approach is Neil Woodford. He has been investing in cheap stocks in unloved sectors via the LF Woodford Equity Income (GB00BLRZQB71) and LF Woodford Income Focus (GB00BD9X7109) funds. But recently these funds have performed poorly. “2017 has shaped up to be an annus horribilis for Woodford, with some high-profile stock blow-ups and run of severe underperformance that has pushed CF Woodford Equity Income, the largest fund in the Investment Assocation UK Equity Income sector, right to the bottom of the performance tables,” says Jason Hollands, managing director at Tilney Group. “Mr Woodford will surely be hoping for a turnaround in 2018 and is taking a contrarian view that is much more upbeat about the UK domestic economy than consensus opinion.”

Investec UK Special Situations (GB00B1XFJS91), run by Alastair Mundy, takes a value approach to contrarian investing. “A true contrarian, Mr Mundy looks for companies where the share price has fallen substantially from its peak,” says Mr Lowcock. “Mr Mundy is effectively a bargain hunter and looks for companies that are undervalued compared with his analysis. To avoid value traps, he looks for companies that have strong balance sheets and are in good financial health.”

Mr Yardley highlights Rathbone Global Opportunities (GB00B7FQLN12), run by James Thomson and Sammy Dow, as a good option for investing in out-of-favour growth companies. Alongside these, the fund holds a defensive bucket of holdings that are less economically sensitive for risk management purposes.