The contrarian strategy

Posted by Willy Lim on 20 March, 2008

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Frequently, profits are made by simply going against the opinion of the majority.

Yours Financially Free,
Willy Lim

The Financially Free Advisor
Renegade InterNetwork Marketing in Asia

Published March 19, 2008

The contrarian strategy

Going against the crowd does lead to long-term results, GENEVIEVE CUA finds out

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A VALUE investor who makes a call to pick up stocks now may be ridiculed as a fool - even if he or she has had a long track record of success.

Portfolio manager Mary Chris Gay of Legg Mason Capital Management, who works with legendary investor Bill Miller, says the time to buy is at the point of ‘maximum pessimism’ - and that applies particularly to financial stocks in which the fund is currently overweight.

This is a time, however, when bank strategists are calling an underweight in equities, even as the market is expecting the US Federal Reserve to cut interest rates by 100 basis points.

Ms Gay says: ‘What we try to do is to maximise the discount between the underlying value of companies and what we believe they’re worth on a risk adjusted basis. The potential upside of our portfolio today is as great as it has ever been.’

Ms Gay is referring to the firm’s flagship Value Fund, run by Mr Miller himself, with US$40 billion in assets. Mr Miller has been variously described in the US media as one of the world’s greatest investors. BusinessWeek, for instance, named him as one of the heroes of value investing, thanks to a 15-year winning streak by the Value Fund against the S&P500, after fees.

The fund, however, suffered a rout in 2006 and 2007, underperforming the S&P500 by about 2,000 basis points. This, as Mr Miller himself wrote in his fourth quarter commentary published last month, was the worst showing since 1989 and 1990, when the fund underperformed by 2,500 basis points.

The current rout, blamed partly on having missed out on commodities’ meteoric rise, has spurred redemptions of some US$3 billion, according to Fortune magazine.

Ms Gay says: ‘No manager has been able to avoid underperforming. Being contrarian means to go against the crowd. The crowd now wants commodities and things that have been going up. But we believe with fairly strong evidence that a strategy of going against the crowd does lead to long-term returns.

‘Right now the contrarian view would be to sell energy and buy financials. . . Whether we’re at the bottom, we’re not smart enough to know. We’re trying to populate the portfolio with things that reflect a very very difficult environment. We’re definitely going to see more writedowns, but the changes in management in some of the big firms, their willingness to take the pain now - we think that’s very healthy and may help set up a recovery at a faster rate.’

She says the firm passed on commodities in 2003, which was a mistake. But she likens buying resources now to buying Internet stocks in 1998 and 1999. ‘There is a long term fundamental case for commodities, but their prices reflect and carry substantial risk. Overall, buying cheap assets and getting out of expensive ones is the way to go.’

But here’s some background. The Value Fund invests in US large cap equities. It is a concentrated portfolio - as at end-December, it had less than 50 stocks. Its holdings may defy what many believe to be value, with names like Amazon.com, Google, Yahoo and Exxon Mobil.

Says Ms Gay: ‘What we try to do is to buy at the point of maximum pessimism which is where we believe we’re at for financials today. And if we truly believe in the underlying value and the price falls further, it increases the future rate of return and we average down.’

The fund’s largest allocations are to consumer discretionary stocks (23 per cent); IT (22 per cent) and financials (18 per cent). She adds: ‘Maybe we are in a recession; if we are it’s too late to be defensive. The time to be offensive is when there is uncertainty, which is the time when the greatest opportunity presents itself.’

One of the metrics the group’s analysts scrutinise is a stock’s return on invested capital. To be considered attractive, a company must generate earnings above its cost of capital. Otherwise, it is destroying value. After all, the market is a discounting mechanism; and the snapback can be swift. Those who stay out of the market in troubled times may find that they are unable to get back in.

Ms Gay cites the record of financial stocks, which also slumped in the early 1990s with the savings and loan crisis. ‘If you bought Citi stock in 1991, at that same year the stock was up 74 per cent. The market was up 30 per cent, but JP Morgan rose 100 per cent. Over a five-year period from 1991, financial stocks were up five times as much as the market.

‘The bottom line is that for long-term investors, buying at a point of great uncertainty - especially for financials, buying at book value or below - has proven historically to be a very good strategy.’ US financial stocks are trading at five to seven times earnings, and the S&P 500 at about 18 times. Based on consensus estimates for next year’s earnings, the latter’s multiple falls to about 11 times.

She tells investors to keep their eyes on their objectives, which typically comprises a long-term savings goal spanning 10 or even 20 years. And tune out the noise. ‘Aligning yourself with someone who has an investment process that is also long-term oriented and focused on value leads to good returns over a long period. But the price of that is the willingness to withstand the volatility.

‘Sometimes a good process leads to a bad outcome. That doesn’t mean you have done anything wrong. Sometimes a bad process leads to a good outcome, and that’s what you often see in trends and momentum. But over a long period of time a good process does lead to a good outcome.’

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