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Why contrarian investors don't get invited to parties

Glenn Freeman  |  15 Feb 2018Text size  Decrease  Increase  |  
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Equities in Australia and the US are over-priced and set to under-deliver, as are fixed income assets, according to Daniel Needham, president and CIO, Morningstar Investment Management.

In a wide-ranging discussion that touched on behavioural topics and the investment process of his global team, Daniel Needham addressed professional investors and financial advisers during the Sydney leg of Morningstar Investment Management's national roadshow this week.

The high relative price of domestic and international equities was a recurrent theme. "We think understanding valuation not only allows you to evaluate good investment opportunities, it also allows you to manage risk.

"Try to avoid owning overvalued asset classes, and where possible try to tilt the portfolio into under-priced assets," he says.

Discussing the merits of value investing, he acknowledges that it is by no means a perfect process, "but one of the key reasons why we think the opportunities are there is because it's really hard to do".

"Value investing is as simple to understand as it is difficult to apply…it doesn't require an astronomical IQ, it requires…a willingness to be independent-minded from the crowd," Needham says.

Providing an insight into the multi-asset process of his team, he explains that Morningstar Investment Management looks at cashflow yield, cashflow growth--which for equities is free cash-flow--and we at valuation--the price-to-fair-value, and then assess the combination of these three elements.

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"We assume that if you bought the asset and held it for 10 years and reinvested those cashflows and that the price was at fair value, this is the return you would get.
"It's a valuation-implied return…it allows us to compare bonds, currencies, stocks and property in one metric," Needham says.

These are calculated monthly across more than 300 asset classes and sectors, and across different markets globally, in taking a bottom-up approach to asset allocation.

Loneliness of the contrarian

"Being a contrarian myself, I can guarantee you one thing: you won't get invited twice to parties, especially if you bring up residential property in Australia--it's only slightly worse than bringing up gold in India," says Needham.

In expounding the benefits of contrarian investing versus other approaches, he draws a clear correlation with being a valuation-driven investor.

"When you're finding oppoortunities, you need to be a contrarian investor if you want to take advantage of valuations.

"As contrarians, you have to be different. These opportunities exist because it's really hard not to copy everyone else," Needham says.

This leads onto behavioural finance, which he believes has "effectively debunked" efficient market theory.

"If [efficient market theory] was a true science, you wouldn’t even really be hearing about it any more…but everybody knows that the market's hard to beat. If you look at the track record of active fund managers, they're not able to outperform the index over long periods of time.

"The market does a pretty good job, it's not shockingly inefficient--in fact it's pretty good most of the time. But we also know that behavioural assumptions are right…it looks like a mug's game according to behavioural science," he says.

A key challenge that contrarian investors need to overcome are their own behavioural biases.

"One of the things we've learnt painfully is that as contrarians, you have to be prepared to be lonely. Because when everyone's buying an asset class and it's very popular, contrarians sit it out. They're concentrated, they're underweight, they're alone," Needham says.

Conversely, when opportunities present themselves, contrarian investors are typically very concentrated on the long-side "and so for us, understanding this diversity breakdown is quite critical".

As an example, he points to the current situation in US markets, where he believes the breakdown in diversity is exacerbated by the excessive use of program trades and exchange-traded funds.

Checklists can be a useful way for investors to overcome behavioural biases. Morningstar's behavioural specialist Steve Wendel highlights the benefit of investors writing a letter to themselves, with reminders of long-term investing goals and discouraging shifting from this.

"We also need to overcome some of our behavioural biases, and checklists can be really useful," says Needham.

"We have a checklist of six things we look at, in trying to build a repeatable process…so asking ourselves is there a diversity breakdown, do investors have very high expectations, is sentiment very negative, is trend volume very low, is volatility very high, and does it look statistically cheap.

In terms of where he sees opportunities, Needham says some of the most popular investments are mostly offering low return opportunities, particularly within developed markets.

"Some of biggest asset classes for Australians, we think are priced to deliver low returns," he says. "So, you have to look outside of traditional equity and bond markets to find opportunities."

On a relative basis, Needham likes global telecommunication companies, UK equities and emerging market equities--particularly the Japanese market.

Morningstar Investment Management holds a significant position on Japanese equities via its real return growth fund. "We were very positive on Japan in mid-2012, and as we did more research, it went from a legitimate value opportunity to a fundamental opportunity."

He says it is characterised by much friendlier shareholder behaviour than in the past, with large Japanese companies now holding a higher ratio of independent directors--something Needham notes is generally correlated with higher returns--and less cash on balance sheet.

"Japan has gone through a significant structural change…a long process, but Japan is coming out of a long deflationary process."


is senior editor for Morningstar Australia

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