Why Contrarian Value Investing Is Both Agony And Ecstasy

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Includes: AUCOY, BT, BTDPF, BTDPY, CPYYF, CPYYY, KGFHF, KGFHY, NGG, NGGTF, POYYF, PYTCF, PYTCY, TPRKY, TVPKF, WPP, WPPGF
by: Stockopedia

Back in 1939, an investor called John Templeton made an unusual series of investments that eventually helped cement his reputation as a legendary contrarian. As America was emerging from 10 years of the Great Depression, Templeton (who was only in his late twenties at the time) sensed an opportunity.

He bought $100 of every stock trading below $1 on the New York and American stock exchanges, paying around $10,400 for stakes in 104 companies. Four years later, 34 of those companies had gone bust, but Templeton had still made four times his money.

He went on to build a fortune by looking almost anywhere in the world to find contrarian value investments. It was summed up in one of his best-known quotes:

"Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."

What it takes to be a contrarian

Contrarianism lies at the heart of value investing. It's the essence of going against the herd and taking psychologically difficult decisions to buy stocks that most of the rest of us won't touch.

These are the investors who are prepared to buy when others are nervous or fearful. They target unloved and distressed companies, and they can be some of the earliest movers when markets hit rock-bottom. It was contrarians who made serious money in the early months and years of recovery after the dotcom crash and the financial crisis.

Evidence shows that human nature is likely to have us running for cover in the face of danger. That's why contrarianism is so counter-intuitive to many investors, even though it can work well over time. Seth Klarman, a dyed-in-the-wool billionaire value investor, made this point in his book, Margin of Safety. In it, he wrote:

"Value investing by its very nature is contrarian... Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period."

But while - as Klarman point out - being a value contrarian can be painful, it's a strategy that has proved to be very successful for some of those who apply it. Investors like David Dreman and James O'Shaughnessy in the US have been practising it successfully for decades, while newer players like Wes Gray and Jack Vogel at Alpha Architect and Nick Kirrage and Kevin Murphy, who lead the global value team at Schroders, take an equally buccaneering approach to contrarian value.

Hunting for unloved shares

So what is it that really defines a contrarian stock? In Stockopedia's StockRank framework for profiling shares based on the strength of their Quality, Value and Momentum, contrarians are marked out by having strong combinations of Quality and Value but poor Momentum. Click here to read more about the components of the Quality Rank and Momentum Rank.

To get an idea of the types of stocks that this investing style picks up, I've applied it to British large caps - but it can be equally applied anywhere in the market. The idea behind the approach is to explore unloved areas of the market where there are stocks with the potential to recover.

Name

Mkt Cap £m

QV Rank

StockRank Style

Piotroski F-Score

Yield (pc) Rolling

Sector

Barratt Developments (OTCPK:BTDPF, OTCPK:BTDPY)

5,583

95

Contrarian

7

7.4

Consumer Cyclicals

BT Group plc (NYSE:BT)

20,434

91

Contrarian

7

7.5

Telecoms

Kingfisher (OTCQX:KGFHF, OTCQX:KGFHY)

6,595

90

Contrarian

5

3.6

Consumer Cyclicals

Polymetal International (OTC:POYYF, OTCPK:AUCOY)

3,069

87

Contrarian

7

5.2

Basic Materials

WPP plc (WPP, OTCPK:WPPGF)

15,315

85

Contrarian

5

4.9

Consumer Cyclicals

Playtech (OTC:PYTCF, OTCPK:PYTCY)

2,506

83

Contrarian

7

4.1

Technology

Travis Perkins (OTCPK:TVPKF, OTCQX:TPRKY)

3,596

83

Contrarian

6

3.3

Consumer Cyclicals

Centrica (OTCPK:CPYYF, OTCPK:CPYYY)

8,022

82

Contrarian

7

8.4

Utilities

National Grid (NGG, OTCPK:NGGTF)

27,755

76

Contrarian

7

5.6

Utilities

Unsurprisingly, the results include some fairly scary prospects, peppered with profit warnings. BT is a good example, where an accounting scandal triggered a profit warning and the CEO is losing the faith of institutional holders. The share price has been falling for two years, and the market just doesn't like it much. It looks cheap, with a ValueRank of 87, but the QualityRank is holding up at 71 - putting it firmly in contrarian territory.

Several others - particularly Barratt (houses), Kingfisher (DIY retail) and Polymetal (gold and silver) - arguably face cyclical uncertainties that have already manifested in profit warnings (or the market thinks they will soon). The question for contrarians is whether they will recover.

So whether it's an embattled stock or sector or a broader market dip, contrarian investors naturally move away from the herd. It's a strategy that takes mental strength but relies on the time-tested rule of value investing that, over time, the market will price fundamentals correctly.

In his book, Klarman said the pain for contrarians is that they can end up being wrong more often and for longer periods than many others. But as Sir John Templeton said: "If you want to have a better performance than the crowd, you must do things differently from the crowd."

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.