Contrarian investing is akin to value investing, but the difference is that contrarian investors will also consider investing in depressed stocks that have high traditional valuation metrics.
Allan Gray chief investment officer Simon Mawhinney says value and contrarian are often considered close cousins – both are focused on the price you pay for an asset. But being able to also purchase companies that may have depressed earnings, and therefore high multiples, gives the contrarian investor a wider playing field on which to look for opportunities.
Contrarian investing also gives investors an opportunity to avoid popular stocks and instead invest in out-of-favour shares at a discount.
“At it’s core, we believe the greatest returns on offer come from investing in companies that are out of favour,” Mawhinney says.
“They’re out of favour because they might have made a few missteps or, more likely, due to a deep and protracted cyclical downturn that the investment community has lost patience with,” Mawhinney says.
He adds they instead take a long-term mindset to investing in the same way a business owner would.
“This allows us to undergo periods of market volatility or share price underperformance as long as we are convinced that the business fundamentals remain sound,” Mawhinney says.
The momentum phase
Allan Gray’s research also sees a great degree of trending in markets in recent years. Sometimes referred to as momentum, trending in markets is where the recent winners continue winning and previous losers continue losing.
Mawhinney points out that there have been various periods of trending over the years, such as the period of extreme trending that preceded the Dotcom bubble bursting, the onset of the Global Financial Crisis, and the extreme dislocations we saw in the aftermath of the pandemic, such as the meme stock bubble.
Generally, the best performing stocks of the previous year usually don’t continue to perform as strongly the following year. Today, size and liquidity appear to be major beneficiaries of the market’s trending, with large, liquid companies leading the field, funded by the sale of smaller, less liquid companies.
“In almost all sectors across the market it is the largest company in that sector that has performed the best over the past three years,” Mawhinney says.
“Valuations in these companies appear stretched relative to the rest of the market and, perhaps more importantly, they are also stretched relative to their own history.”
Trends are both a blessing and a curse for contrarian investors. “It’s a blessing because, as contrarian investors, we’re often looking to buy in depressed areas of the market and strong trending creates particularly attractive opportunities in the stocks that have been left behind” he says.
“But trending can also be a curse. If ‘winners’ keep on winning, the ‘loser’ stocks will take longer to recover, so our portfolio performance suffers while we wait.”
However, investors shouldn’t be left with the impression that any out of favour stock can be bought with an inevitable rise to follow – some stocks have been marked down for very good reason and some may never recover.
“On the other side of every buy and sell decision that we make is someone who’s taking the exact opposite position and those people are likely to be smarter than us,” Mawhinney says.
“Understanding what they’re thinking is incredibly important in making sure that we protect ourselves from the downside.”
Morningstar chief investment officer, Matt Wacher adds that “yesterday’s winners” have traded on momentum, and so have become detached from a sound valuation.
“While the momentum trade makes those that focus on valuation uncomfortable as markets get on a tear, patience… sets up an investor for longer term gains rather than a quick sugar hit,” Wacher says.
