Beyond Simplistic Thinking: A Matrix for Contrarian Investing

I have been seeing a number of posts about retail stocks in which the author expressed an opinion on the stock based (in part) on how the shopper was treated at the store. The basic theme of the posts is along the lines of "XYZ Company is in big trouble because when I went to the store the salesclerk was rude (uninformed, lazy, sloppy, etc.) and I can't see why shoppers will ever go there again."

Although Peter Lynch (the famous portfolio manager of the Magellan Fund) supposedly made a ton of money in Gap Stores back when it was a young growth company because his wife liked shopping there, most investors do not make important decisions based on one personal experience. If the investor had already looked at the numbers and was leaning one way or the other on a stock, a visit to a couple of stores might help the decision, but in most cases, one isolated data point (of any kind) is probably not sufficient reason to make a major investment decision.

This is the same kind of simplistic thinking that we hear all the time in the media's coverage of the stock market. "The US consumer is being hurt by higher gasoline prices, so avoid the retail stocks," they say (for example) and I have to cringe because the markets are not that simple. The American public has been spoon fed so much electronic pablum over the years that it's not surprising that the media coverage of the equity market is no more rigorous than any other type of coverage. *end rant*

Anyway, I wanted to share an idea which comes from my days at Columbia University where I did my post-graduate work. At that time, the Boston Consulting Group was all the rage and its famous matrix was ubiquitous in the classroom. The matrix (or box, if you will) looked something like this:

BCG Sample

I think this matrix is an excellent tool for understanding any concept that can be defined by two variables. The illustration above shows that the best stocks are those with high growth rates and high market share. The worse have neither. The other areas depict the "cash cows" -- stocks that will not have much growth but are dominant in the industry and the "question marks" -- companies that have the potential to become "stars." For my purposes today, I will re-label the matrix to look like this:

MPG BCG Matrix

This one picture captures well my investment philosophy. Let me break it down for you a bit. Aside -- the notions of "quality" and "relative valuation" are highly subjective and in my view represent the "art" of the investment process. Although I do not spend a lot of my time trying to stick any of these labels on the stocks I am analyzing or owning, I think most experienced investors could quickly put most of their holdings into one of these boxes. That, in my view, is the power of a simple tool like the BCG matrix.

"Boring" -- high quality companies often command a high valuation exactly because they have proven to the market their greatness. Continued high valuation relies on continued excellence in execution and the ability to change as needed over time. For me, these are boring because they are over-followed, over-analyzed and potentially over-owned. The combination of high expectations and high valuation often leads to negative surprises. I am happy to own them but will rarely buy them.

"Take Profits" -- lower quality companies sometimes reach higher-than-expected valuations. Sometimes this is due to unusually depressed earnings. Sometimes expectations of a takeover can affect the multiple. Whatever the reason, I am always tempted to sell the shares of a weak company whose shares command a premium valuation. When these stocks are in my portfolio they usually have migrated from the "Analysis Needed" box.

"Get Excited" -- when a star stumbles, it often ends up in this box. When this happens, investors and market commentators will often question whether this is a short-term setback or the end of the firm's greatness. When indeed it was proven to be only a setback, these stocks will often move back into the "boring" box. So, if one buys these stars when setbacks arise, it can often be very profitable. Sometimes the lower valuation can signal the end of greatness (think Starbucks, for example). Trying to determine which it might be is, in my view, the art and fun of this business. I think many of the stocks I buy fall into this box.

"Analysis Needed" -- some stocks deserve to be cheap. Sometimes, however, the valuation of a "bad company" can get so low to be compelling. I would argue that if the price is right, I would be willing to buy any stock, regardless of its "quality." This is, ultimately, the contrarian's conceit and why most people have a problem with deep value, contrarian investing. This is another area where I spend a lot of my time and where I often will buy stocks.

Many of the stocks in this box are potential "value traps," that is, stocks that look cheap but will never make you money. I have been known to buy them from time to time as well. It takes a lot of digging through the dirt to find the rare gems that have the potential to either warrant a higher valuation or actually turn around fundamentally to become a better company. Either way, the rewards can be very attractive.

So there you have it -- another peek into the mind of Mike Goodson, contrarian investor. Please refer to my private blog for a discussion of where I think my current holdings fit into this matrix.