By Kash Hashemi, CFA, MBA
IN THIS ISSUE: In the world of Finance, going against the grain is sometimes bold, sometimes ill-advised, but usually both. So when looking at an investment that’s fallen out of favour or ignored by the market, how does one know when it’s right to buy, or even if it’s a good idea? In this edition of Tactics, Portfolio Management team member, Kash Hashemi, guides us through the discipline of Contrarian Investing.
Many years ago, as a recent know-it-all University graduate, I optimistically embarked on a career search with high hopes of landing a well-paying job that would make any mother proud. After more than a few interviews, it became dishearteningly apparent that it would actually require years of hard work.
I recall one particular interview where I was asked to define what it means to be a contrarian. After an uncomfortably long pause, I remembered a small blurb from one of my many overpriced Finance textbooks that described contrarian investing as “a sub-set of the value investing discipline.” I proceeded to provide the interviewer with a standard textbook answer: a contrarian is an investor who buys securities that are out of favour according to some well-defined, fundamental measures, such as low price-to-book ratios or high dividend yields.
Before I realized I had placed my foot directly in my mouth, the interviewer dismissed my shallow response by pointing out that he asked me what it meant to be a contrarian, not what it meant to be a contrarian investor. He also pointed out that my definition for contrarian investing suggests that any stock trading at low price-to-book ratios or offering a high dividend yield is a contrarian investment, which was surely not true. To no one’s surprise, I didn’t get the job. The good news is that life tends to give you second chances. This time, I will attempt to define what it means to be a contrarian by:
- Exploring the contrarian thinker and offering a nonfinancial example of contrarian behaviour;
- Defining contrarian investing;
- Providing a simple example of a contrarian investment; and
- Examining current contrarian signs.
The Contrarian Thinker
In some ways, contrarians are a little like comedians in that they test the boundaries and challenge the status quo.
Comedians often go out of their way to present ideas that sound absurd. Sometimes the audience laughs. Other times the level of absurdity exceeds the audience’s ability to comprehend what is being said, resulting in awkward silence. A contrarian thinker offers opinions that are amusing at times and incomprehensible at others, also often resulting in awkward silence.
However, unlike a comedian, a contrarian doesn’t just conjure up absurd ideas. Normally, the contrarian’s thought process involves the direct or indirect calculation of probabilities and outcomes in an attempt to prove that what he or she is saying is not as far-fetched as it appears. Contrarians are generally well aware that their ideas sound crazy, but they’re also confident that their ideas aren’t as crazy as they sound.
One of my favourite non-financial examples of contrarian thinking comes from the book ‘Fooled by Randomness’ by Nassim Nicholas Taleb, a brilliant book that forces you to think outside the box. The book begins with the story of Solon’s warning to Croesus, King of Lydia. Croesus, one of the richest men of his time, was visited by the Greek legislator, Solon. Solon was indifferent to Croesus’ wealth and told him: “The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyments, or to admire a man’s wealth that may yet, in course of time, suffer change. For the uncertain future has yet to come.”
In other words, “it ain’t over ‘til it’s over.”
Years later, Croesus would lose in battle to the Persian King, Cyrus, be stripped of his riches, and concede to Solon’s wisdom. He realized that it was impossible to be called the wealthiest man who has ever lived, because there was a possibility, albeit a miniscule one, that the wealth could be taken away.
What does this have to do with contrarian thinking or investing? Solon displayed a contrarian thought process because he understood skewness: that frequent success is meaningless if failure is too costly to bear. Contrarians apply this concept by considering both the probability of an event occurring and its outcome. This is in contrast to normal human behaviour, which tends to ignore the very low probability event (being captured by King Cyrus) regardless of the severity of the outcome (being robbed of your wealth).
The Contrarian Investor
Very generally, the contrarian investor displays intellectual independence with a large dose of skepticism about consensus views. It is an attempt to profit by betting against the consensus. Essentially, the contrarian does three things:
- Watches for popular and neglected areas of the market
- Comments on the crowd behaviour in markets
- Uses a very small portion of total investable funds to act on a contrarian investment idea
Contrarian investors know that they’ll be wrong more often than right. They also understand that they don’t need to be right most of the time, because when they are right, they expect the payoff will be large enough to make up for all the times they were wrong.
The point here is that a contrarian utilizes the state of investor psychology as a form of idea generation. And here is where the contrarian may have a leg up, because if there’s one thing that’s fairly predictable about markets, it’s investor psychology. At market tops, jubilation turns into denial, which eventually turns into reality, which turns into fear, which results in capitulation at market bottoms. At market bottoms, investor psychology works all the way back up to jubilation again.
The challenge, of course, is that nobody knows how long this process is going to take and how high or low the crowd’s psychology will reach. In this regard, the contrarian knows full well they cannot predict with certainty the exact time to get in or get out.
On paper, the strategy sounds very simple. In practice, it requires a different mentality, one which most humans are just not wired for. For one, it can be extremely uncomfortable to be wrong and contrarian at the same time, especially when money is on the line. Secondly, most people grow up being taught that the majority rules, so having a minority opinion causes them to examine why they are wrong as opposed to why the majority might be wrong.
This reminds me of times when, after writing an exam, I would ask two or three of the “smart” students in the class how they answered certain questions. If their responses were similar to mine, I would get a sense of comfort. It never really occurred to me that our responses could be the same and incorrect all at the same time.
In the world of Finance, we are constantly reminded about a study done for the SEC (Securities & Exchange Commission) which came to the conclusion that 90% of all options* expire worthless. This means that 90% of the time, the buyer of an option will lose money.
Because of this piece of data, some very well-respected minds in the financial industry make the claim that buying options is a losing proposition. They therefore conclude that selling options is a winning proposition since option trading is, by definition, a zero-sum game (i.e., your gain is someone else’s loss and your loss is someone else’s gain). Sounds pretty logical, right? Actually, if you do the math, it is not that logical at all.
Assuming we can take the study results as fact, the idea that 90% of all options will eventually be worth zero should be meaningless. This is because it only takes into account the probability of an event occurring while completely ignoring the potential outcome. In other words, what matters is the amount of money that was lost 90% of the time vs. the amount of money that was made 10% of the time.
*An option is a derivative security, a financial security whose characteristics and value depend on (or are derived from) the characteristics and value of an underlying security. For the purpose of this discussion, I will greatly simplify the example such that it is not necessary to understand how options work.
A simple example (though admittedly extreme) helps illustrate this point:
Let’s consider the $10,000 purchase of a security and assume that 10% of the time it will be profitable. Half the time it will generate a total profit of $150,000 and during the other half, it will generate a total profit of $300,000. Let’s also assume that 90% of the time, this security will eventually be worth zero, thereby creating a loss of $10,000. From here, we can create the potential outcomes as shown below.
In this greatly simplified example, we can calculate the expected dollar profit, since we know the probabilities and outcomes for each of the three possible scenarios:
Here is a situation where the probability of loss was 90%, but the expected outcome was a 135% gain (or $13,500 profit on a $10,000 investment). This is what skewness (or asymmetry of returns) is all about, and this is what contrarian investors pay attention to.
To the contrarian investor, the $10,000 investment has an expected profit of $13,500. Sounds good, doesn’t it? Well, yes and no. It is a good expected outcome, but if you back the truck up on this trade, you will be penniless 90% of the time. However, if you put a very small portion of investable funds to this strategy, over the long term (at least statistically) you should do very well on the trade. As mentioned before, in theory this is how a contrarian looks to make money. In practice, however, it’s quite difficult.
Playing Armchair Contrarian
Now let’s examine a few current themes for contrarian investing in today’s turbulent market. I would like to preface this section by providing you with the classic cover-your-butt clause and say that I do not recommend you pursue any of these strategies as you will likely lose money on them. These are simply examples and are meant to supplement this discussion on contrarian views.
With house prices in certain parts of the U.S. falling off the edge of a cliff over the last year or so, one would automatically assume that prices somewhere in the U.S. would appeal to contrarians. Maybe so, but measuring how much house prices have dropped is not enough; one must also look at where they came from. In this regard, most contrarians would shy away from an asset unless it is hitting decade (or sometimes multi-decade) low prices. Houses in the U.S. do not qualify. There are probably some areas in the U.S. (e.g., Detroit) where home prices are at multi-decade lows and would appeal to a contrarian, but on average they are not.
Buying into oil or oil stocks at this point is most assuredly not a contrarian investment. Prices have been rising consistently and above most people’s expectations for the past eight years. Oil was a contrarian investment at the beginning of the decade, when many analysts were debating whether US$10 or US$20 per barrel was the long-term price. In fact, a case could be made that oil is at multi-decade highs, so if there is going to be a contrarian view, it should be bearish – that oil prices are in a bubble and poised to fall. Interestingly enough, general Wall Street sentiment actually expects a fairly sharp correction in the price of oil. In order to consider this a contrarian prospect, there must be consensus agreement in the market and stocks must be priced accordingly.
Similar to oil (although not to the same extent) gold prices have been rising consistently since the start of the decade. Gold was a contrarian investment in the early part of the decade when it was fetching less than US$300/oz. Contrarian thinker and author of “Financial Reckoning Day”, Bill Bonner has made a name for himself by calling his trade of the decade in 2000, where he sold the Dow Jones and bought gold. It is not the end of the decade yet, but it is far from the beginning.
As for North American stock markets, the Dow Jones or S&P 500 could hardly be called contrarian investments today. With trailing price-earnings ratios around long-term averages and the prospects for earnings looking weaker by the month, it is unlikely that we are about to embark on a long-term bull market as we did in 1982, when buying shares of the Dow Jones was truly a contrarian move. Moreover, according to an April 26 Barron’s survey of Institutional Investors (the so-called smart money), a whopping 81% of respondents are either bullish or neutral on the prospects of the stock market over the next year. This type of sentiment is a contrarian’s worst nightmare.
How about Japan? In 1990, the Japanese stock market began to collapse. The index hit an index price peak of 39,000 and then starting dropping like a stone. At 25,000, analysts viewed the crisis as being over; every time the Nikkei fell, it was viewed as another buying opportunity. But it just kept getting worse and worse. Today (May 2008), you can buy the Nikkei for 13,655 – a 65% discount from its peak. While Japan is full of problems with its aging demographics, closed border policies, high levels of debt, and relatively low domestic consumption to name just a few, all of this glum news is exactly what makes for a perfect contrarian bet. That being said, there is at least some hope for this battered economy, including the fact that Japan is one of the few countries in the world that pretty much avoided the hodge podge of sub-prime investment vehicles.
The purpose of this newsletter is not to make general or specific investment recommendations, but to make observations about how contrarian investors tend to think and to provide examples of the types of scenarios that appeal to them. I do not pretend to be a contrarian investor, although I am sure I have, in the past, unknowingly made some investments that would be considered contrarian. I also don’t think of this investment style as a good way to accumulate wealth for retirement.
The main point is that contrarians tend to think outside the box. In looking for themes, contrarians prefer small probability events with big payoffs and, consequently, tend to lose money on their trades more often than they make. But unlike professional sports, investment success is not measured by the number of wins vs. the number of losses. Contrarian investors care about the cumulative ‘score’ in each of the ‘games’ they play, win or lose. If you can win big and lose small, then it makes frequent losing a tolerable price to pay.
With logic like that, it’s probably a good thing I wasn’t interviewing for a position with a professional sports franchise. Or maybe I should have become a comedian after all.