Investing against the herd
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In this first article in a regular series, Ibbotson Associates head of alternatives and capital markets Michael Coop explains the concept behind contrarian investing. Ibbotson Associates is a Morningstar company.
Contrarian investing is about looking for undervalued and out-of-favour investments and avoiding highly priced and popular investments.
As John Maynard Keynes wrote: "The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive."
Investors are prone to extremes of optimism, like the 1999 mania for IT companies, and pessimism, like the depths of the global financial crisis. These present opportunities to profit, when the extreme scenarios priced in do not occur.
The challenge is putting this into practice. First, you need to derive a fair value against which you can compare the price to identify mispricings and consider what might happen in extreme conditions.
Second, you need to understand how other investors are positioned, whether they like or dislike the investment and why.
Third, you need the nerve to take positions that are unpopular and seem scary at the time. Even a veteran investor like GMO co-founder, Jeremy Grantham, was battling fear when he famously bought shares in the first quarter of 2009, titling his client letter "Reinvesting when terrified".
Fourth, you need patience and the stability of capital to hold positions long enough to benefit, sometimes for many years. It took four years for Lansdowne Partners, a UK-based fund manager, to profit from its position against Northern Rock, a UK bank that ultimately went bust.
Note that there is no point in being contrarian for the sake of it. Bouts of excessive optimism or pessimism occur now and then, rather than all the time. Conventional wisdom is often right.
There have been attractive contrarian opportunities in recent years. In 2010, Australian real estate investment trusts (AREITs) were trading at 15-20 per cent below book value, after debt levels were reduced and fringe assets divested or written down.
They remained reviled by domestic yield-based investors, who suffered losses of more than 50 per cent in 2007-2008. From 2011 to 2012, the crisis in Europe drove local asset prices down to the low end of their historic ranges as investors preferred the US and emerging markets.
Japanese equity prices had also fallen to very low levels by mid-2012, with minimal foreign investor exposure. From 2010 to 2012 emerging market bonds, commodities and commodity-driven currencies, especially the Australian dollar, were very popular and prices and yields moved to the expensive end of their historic ranges.
Right now there are signs that investors are falling in love with US equities, judging by the high level of prices relative to sustainable valuation levels and a variety of measures of investor positioning and sentiment.
Emerging market equities and bonds have fallen out of favour, though are not outstandingly cheap as a whole, while some emerging market currencies have fallen also but could still fall further.
Most fixed-income markets also appear to be overpriced following many years of very low interest rates across developed economies.
We believe the majority of asset classes are in fact overvalued to a significant degree, so for the contrarian there are more "short" than "long" opportunities and cash is appealing as a parking spot until better value emerges.
The next article in the series will explore some contrarian opportunities.