CONTRARIAN VALUE: EASIER SAID THAN DONE
“We consider ourselves long-term, patient, contrarian value investors” are the first words in the “How We Invest” section of our website. But what do they mean in practice?
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Measures of Value
Even amateur investors are aware that the dollar price of a stock is meaningless: there is no logical reason to assume that a $5 stock is cheaper than a $10 stock without knowing what exactly you are buying for those prices. Warren Buffett made this point with his usual flair for words: “Price is what you pay. Value is what you get.”
This is why, when discussing value, we normally use ratios, which compare the price of a stock (what you pay) to the company’s sales, earnings, cash flow or assets (what you get). For example, a stock’s price/earnings ratio (P/E) — which is widely used to measure current value — represents a company’s share price divided by its earnings per share. When the P/E rises or drops, it is therefore legitimate to assume that the stock is becoming more, or less, expensive.
The Crowd of Investors Tends to be Manic Depressive
Extraordinary Popular Delusions and the Madness of Crowds, an 1841 book by Charles Mackay on early speculative bubbles, remains the basic reference on the enduring propensity of crowds to behave irrationally in financial matters, oscillating between euphoria and panic in recurring cycles. (Project Gutenberg — https://www.cmi-gold-silver.com/pdf/mackaych2451824518-8.pdf)
Thus, over short or intermediate periods, investors’ opinions often have a greater influence on the performance of a stock than the operating or balance-sheet statistics of the underlying companies. P/E ratios, for example, fluctuate much more widely that would be justified by company fundamentals alone.
The father of value investing, Benjamin Graham, explained this apparent disconnect by saying that “in the short run, the market is like a voting machine” [tallying up which firms are popular and unpopular] while “in the long run, the market is like a weighing machine” [assessing the substance of a company].
Importance of the Timeline
Over the very long term (often decades), stock prices tend to track companies’ fundamentals, i.e. earnings, which tend to move with sales and assets which, in turn, tend to follow economies’ growth rates and productivity.
But company fundamentals change relatively slowly. It makes little sense to attribute stock price changes even over months to fundamental progress: what they really are is changes in the Price/Earnings ratio (P/E), where P moves a lot and E relatively little. Such short-term fluctuations are principally due to investors’ perceptions of probable future developments. These perceptions, as purely psychological phenomena, can be volatile to the point of irrationality.
My own observation is that, over the near-term, stock market fluctuations are perhaps 90% to 100% determined by crowd psychology and only 10% to 0% by changes in fundamentals. As the time horizon lengthens and the market becomes more of a “weighing machine”, to use Graham’s term, the factors influencing stock prices trend towards 90% fundamentals and 10% psychology.
An Apparent Contradiction
In theory, one would expect the results of value and contrarian investing to be highly correlated. After all, the price of a stock is the result of a bidding process. Thus it should reflect the popularity of that stock among investors: the higher the P/E ratio, the more popular the stock and therefore the less attractive to a contrarian. Conversely, the lower the P/E ratio, the less popular the stock, which should make it appear as a bargain to contrarians.
But in practice — to quote baseball immortal Yogi Berra — “In theory, theory and practice are the same. In practice, they are not.”
When looking at large samples of stocks over long periods of time, there is little doubt that buying stocks at low P/E ratios produces better returns in the ensuing 10 years or more than buying at higher P/E ratios.
Elsewhere I have cited many studies supporting that statement. Today’s example comes from Dreman Value Management, which measured the performance of the 500 largest US companies over the 40 years between 1970 and 2010. It is interesting because, unlike several other studies, it seems to have made no adjustment to P/E ratios and did not use moving averages.
Including dividends, stocks with the lowest 20% of P/E multiples increased 15.3% annually on average, while stocks with the highest 20% of P/E multiples increased 8.3% annually. (The performance of the S&P 500 Index fell somewhere between the two groups). Thus, in terms of batting average, investing in stocks with low P/E ratios should be better than investing in stocks with high P/E ratios.
The contrarian approach appeals to investors who believe in the psychological instability of crowds. But it really is at its best only at the climactic extremes of euphoria and depression. The rest of the time, and particularly over shorter periods, it’s at a disadvantage compared to so-called “momentum” investing.
Early students of behavioral finance searched for anomalies in financial markets, i.e. asset behavior that could be predicted more or less precisely. In contrast, prices would normally be expected to move in random fashion, depending on crowd moods.
Momentum is a concept borrowed from physics, referring to a force that allows something to continue moving on its past trajectory as time passes. One of the first anomalies detected by behavioral finance researchers was momentum: a security that had followed a given price trend for a number of months, for example, could often be expected to continue further on that trend. Many investors still use momentum investing in some form or another.
There are two problems with momentum investing, however:
- it works best in the short term and thus encourages heavy portfolio turnover
- it is hard to distinguish between short-term cycles within a trend and major reversals in long-term trends
As a result, it has been said that momentum trading is right most of the time but wrong when it really counts (at major market reversals).
Contrarian investing is not well adapted to recognize and exploit short-term market fluctuations. Most psychological excesses such as irrational exuberance forewarn major trend reversals. The timing of such reversals is unpredictable, though, because excess can always become even more excessive – for a while. The forte of contrarian investing, though, is that it may help prepare for large corrective moves when exaggerated mood shifts among investors are detected.
Investing Is Not a Science
One of my early mentors explained the failure of most investors to exceed or even match the performance of “the market” by the fact that people persist in seeking certainty in an uncertain world. Many investors and observers tend to envision investing as an exact science, delivering precise and undisputable answers and responding to immutable laws. Unfortunately, investing never was a science and probably never will be. It is not even a matter of intelligence. Investment success is much more a matter of common sense, character and patience.
A well-worn adage says that “It is better to be roughly right than precisely wrong.” This applies well to the process of investing. For example, I believe that, rather than searching for the next Apple, Google or Amazon, we should be aiming for a superior “batting average,” where above-average gains more than offset fewer and smaller losses.
Invert, Always Invert
To achieve a good batting average with a portfolio of manageable size (which we estimate at 30 to 50 securities) we must first assemble a universe of potential investments whose odds of producing superior performance over time are above average. According to Investopedia.com, approximately 630,000 companies may be traded publicly throughout the world, so the selection process could be daunting even with the sophisticated computer-screening tools now available.
In addition, faced with one of our favored disciplines that works “most of the time except when it counts” (momentum investing) and another that works when it counts but with imprecise timing (the contrarian philosophy), our selection process cannot be surgically precise. But, as Churchill said of democracy, we view contrarian value investing as “the worst form of investing, except for all the others.” Thus, we elect to refine the process rather than the discipline.
When faced with the task of solving an extremely complex problem, I am always reminded that nineteenth century German mathematician Carl Jacobi reportedly urged his students to “invert, always invert.” I am no mathematician. But as an investor, I believe that, rather than trying to select a few winners out of a very large and complex stock universe, it makes sense to first reduce the size of the challenge by eliminating as many stocks as possible which DO NOT qualify for our attention.
How We Eliminate
We are exposed to a constant flow of new investment ideas — from our own research, various specialized research services, and a network of peers with whom we regularly debate. This produces a more than sufficient sample from which to extract the 10-12 new ideas a year we need, considering that our 30-50 stock portfolios are intended to have a low (one-third or less) annual turnover rate.
From this flow of new investment ideas, we normally first eliminate companies that are too financially leveraged for our conservative taste. This is particularly essential now that artificial central bank liquidity and low borrowing rates have created a financial climate that is much riskier than most people realize.
Our contrarian approach usually allows us, even tempts us, to invest in companies that have been hurt by outside developments that we deem to be temporary or cyclical. On the other hand, based on the cockroach theory (“there is never just one cockroach in the kitchen”), we try to eliminate companies that may be accident-prone due to reckless management, overly promotional communications or questionable accounting.
We also eliminate stocks that have been rising strongly for a few years, sport valuation ratios reminiscent of past bubbles, or are strongly recommended by momentum-type brokers and advisors.
Once this trimming down has been completed and we are left with a reduced universe of candidates for a good long-term batting average, we submit the survivors to our normal investment selection process as described elsewhere on our website (www.sicartassociates.com).
This is an ongoing process, which is independent from macro considerations about economies and stock markets (although obviously candidates for selection are more abundant after overall market declines).
Thus, rather than being “perma-bears,” we are rational optimists: declining stock prices mean cheaper investment. Contrarian value investors should become euphoric when the crowd succumbs to panic.
François Sicart – March 2, 2018
This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.