I follow a value investing strategy for my contrarian portfolio. I religiously adhere to Warren Buffett's investing maxim 'to be greedy when others are fearful and fearful when others are greedy'. In addition, I hold an optimistic economic outlook both for the US and Europe and I think we are in a midst of a prolonged bull market. Throughout the year I have traded very infrequently but tried to take advantage of fear-driven sell-offs that occur with fascinating regularity. I am not a market-timer whatsoever, but purchasing companies that have fallen on hard times and then waiting patiently until the market corrects its mispricing, has been by far the most profitable investment strategy for me over the last five years.
Going into 2014 I am confident that the investments in my contrarian portfolio offer outsized return potential. All equity investments have in common that their issuers face short-term challenges that the market mistakenly considers to be secular in nature. Traditionally, many investors are overly influenced by negative company news and headlines. The most prominent examples for such short-term challenges relate to a company that needs to restructure because of faltering sales, or a firm that is falling behind competitors in terms of product innovation and competitiveness or evaporating catalysts such as a collapse of a buyout transaction. Most investors will use those events as an excuse to avoid the stock of such companies because of the domineering uncertainty surrounding the investment.
However, times of uncertainty is usually the time in which mispricings are largest because pessimism has pushed investors to other segments of the stock market. As a contrarian, I am specifically looking for investments where investors have given up hope, extrapolate negative events and already see a company in bankruptcy. Going back to 2008/2009 Warren Buffett attested to his contrarian nature by buying stakes in General Electric (NYSE:GE) and Goldman Sachs (NYSE:GS). Few would have done so at that particular point in time. He also continued to buy a variety of other businesses during the financial crisis and supported massive capital expenditure programs for Berkshire's subsidiaries. With the economy now doing much better than in 2009, his bets are paying off.
I found the maxim 'to be greedy when others are fearful' to be extremely powerful as it captures the essence of the contrarian mindset. Fortunately, the stock market offers investors contrarian opportunities all the time and we do not depend on black swan events that threaten the viability of global banking like in 2008. Many companies in my contrarian portfolio are extreme, anti-cyclical positions that are challenging conventional thinking. Naturally, many of those companies have nasty charts and a stream of negative news/speculation has sent the stocks into a tailspin. A few examples include Alcatel-Lucent (NYSE:ALU), Potash Corp. (NYSE:POT), Radian (NYSE:RDN), MGIC (NYSE:MTG), Fannie Mae (OTCQB:FNMA), Mosaic (NYSE:MOS), Barrick Gold (NYSE:ABX) and American International Group (NYSE:AIG). The highest conviction plays of my contrarian portfolio for 2014 are BlackBerry (NASDAQ:BBRY), J.C. Penney (NYSE:JCP) and BP (NYSE:BP). I believe that all of those companies have outsized return potential and both BlackBerry and J.C. Penney have a reasonable chance to double in value over the next 12 month.
BlackBerry has become one of the favorite tech investments in the fourth quarter of 2013. The company went through some excitement as Fairfax Financial made a $9 per share bid with the intention to take the company private. I argued at the time that the deal wasn't a good bargain for shareholders mainly because investors would be deprived of a realistic takeover premium. I estimate that BlackBerry's operating assets including patents are worth at least $9.53 per share not considering any cash or investments held on BlackBerry's balance sheet. Even the low estimate would justify significant price appreciation for BlackBerry's shares.
The challenge with a BlackBerry investment is that investors are almost entirely focused on the loss-making hardware business. Investors have to realize that the device unit is not defining BlackBerry. Nokia's (NYSE:NOK) device business attracted quite a decent $7 billion offer from cash-rich Microsoft (NASDAQ:MSFT). Google (NASDAQ:GOOG) also acquired Motorola Mobility to get its hand on a hardware manufacturer and offer cheaper phones as a result. As the economy improves further in 2014, many companies will direct their focus on growing and consolidating market share. The partnership with Foxconn is a first step to relieve the company from cost pressures and to capitalize on Foxconn's manufacturing efficiency. Other strategic companies could come forward at any time and I do believe that BlackBerry's device unit will ultimately have to be sold. A bid from either a financial or strategic buyer for BlackBerry's device business could be a meaningful catalyst for BlackBerry shares. Many investors might think that BlackBerry's hardware business is too unattractive for any company to purchase. However, that also was the perception of Nokia's business until it was sold to Microsoft: The shares are up 100% since then.
J.C. Penney is another contrarian position of mine that struggles with contracting revenues and a loss of investor confidence. J.C. Penney was on the radar of a lot of activist investors over the last couple years, most notably Bill Ackman of Pershing Square Capital. I did write an article a few month ago about the dynamics of the hedge funds business which likely contributed to the closure of Pershing's J.C. Penney position and I have related to Ackman's over-confident tendency to make massive, concentrated bets. As is sometimes the case, those positions can move against you: His experience with the ill-fated Herbalife (NYSE:HLF) short and his losses on his J.C. Penney investment didn't do anything to increase his street credibility.
I argued at the time that his J.C. Penney sale is related to his inability to influence corporate governance practices at the company and reputational pressures have led him to cut his losses. However, J.C. Penney seems to have been overly punished and the shares have moved down way too quickly. Since February 13, 2012 J.C. Penney shares have lost 79% of their value and shares accelerated their decline after the company announced a capital raise in September. While a capital increase clearly signals that a cash-challenged company needs shareholder help, the successful capital raise shows that management has the confidence of investors that it can turn the company around. Recent information about comparable store sales has been encouraging: Comparable store sales in November increased 10.1% y-o-y.
J.C. Penney's chart looks about as nasty as they come. However, I believe the nearly $1 billion capital raise could very well mark a turning point for the company. Corporate governance conflicts don't dominate the headlines anymore, the capital increase has shown that investors still believe in the company, restructuring programs are under way and comparable store sales are rebounding. Improving consumer spending could provide further tailwinds for shares of J.C. Penney in 2014.
BP is another company that could make a contrarian comeback in 2014. The oil- and gas major still suffers from litigation-related expenses and settlements in connection to the 2010 Deepwater Horizon oil spill in the Gulf of Mexico. I actually bought BP after I read Whitney Tilson's thesis on BP. In his original thesis (very well worth a read) he compares the Deepwater Horizon oil spill with other large oil spills in history and basically concludes that BP, due to its extremely high profitability, will be able to afford both clean-up costs and settlements. In the midst of the oil spill disaster BP marked a Low of $27 per share and investors who acted in a contrarian fashion would have been sitting on massive gains. It literally pays to pay attention to companies that are going through rough times.
Since July 2012 BP has been fairly constantly trading in a narrow range of $40-45 and only in November 2013 managed to break out at the top. Even though the break-out is a positive for the stock, large groups of investors still chose other large-cap oil companies over BP due to the implied settlement risk. I have written before that I think that the majority of oil spill related costs has been accounted for and BP is going to put up massive resistance when it comes to paying out fraudulent and unjustified claims. BP currently has a dividend yield of 4.7% and trades at a low P/E ratio of 9.4. BP remains among the cheapest companies in the large-cap oil- and gas sector.
Contrary to what many investors think, I believe the three companies presented above offer outsized return potential and limited risk since their share prices have been driven so low. All companies have in common that negative perceptions determine the average investor mindset. BlackBerry and J.C. Penney have the most return potential since expectations are so low that beating such expectations isn't too difficult. EPS surprises or strategic asset sales could further provide boosts to the share prices of such companies. I generally expect a higher volatility level for both BlackBerry and J.C. Penney as opposed to BP. All three companies are not investments for widows and orphans but for investors who have the stomach for short-term volatility and the patience to sit out negative sentiment.