The long-term approach

22 October 2019

Jayson Forrest

Jayson Forrest is the managing editor of Money & Life Magazine.

Contrarian investing is a disciplined, long-term approach to investing, requiring patience.

“Be fearful when others are greedy, and greedy when others are fearful.” It’s one of Warren Buffet’s most famous quotes and beautifully sums up his approach to investing.

Considered to be the worlds most successful investor, Warren attributes his success to a patient, long-term approach to investing. In fact, you could say he is a good example of a contrarian investor.

What is contrarian investing?

According to Chris Inifer Head of Retail Strategy at Allan Graycontrarian investing is foremost a philosophy and approach to investing, as opposed to an investment style. 

As the name suggests, its an approach to investing that is contrary to more popular approaches, which enables you to resist trends and not follow the crowd. It ultimately results in very meaningful differences in portfolio holdings and could deliver better returns than the broader market over the long-term,Chris says.

Its an approach that tends to exhibit deeper value characteristics, but is not necessarily exclusively value in style. The main focus is on valuation and looking to buy companies at prices significantly less than their intrinsic value.

Such investment opportunities often occur when companies are experiencing challenges or problems, and its these challenges that cause investors to become fearful. This fear can result in investors selling at low prices that are often attractive to long-term contrarian investors.

As opposed to managers that exhibit a strict value bias, contrarian investors may also find value in companies where their future growth prospects are not being rewarded by the market, or perhaps where companies are not well covered by the market and limited research on them is available,Chris says.

According to Lonsec Investment Solutions, Chief Investment Officer, Lukasz de Pourbaix, a contrarian approach is effectively investing against the market.

Its a deeper value type of investing, where youre not chasing last years winner, which means that investors typically have different types of exposure relative to other exposures, like a growth style manager,he says.

The good and bad

So, what are the pros and cons of contrarian investing?

Chris concedes its an interesting question, believing the pros and cons are often the same.

For example, a contrarian approach is long-term in nature. That means we need a business owner mentality, not a share trader mentality. We tend to invest in companies as if we are buying the entire business, not just looking to trade a few shares in that business,he says, adding that in reality, the investment is limited to a percentage of the company.

Approaching an investment with a business owner mindset, gives the investor a deeper understanding of how a business operates, not just a view on the next short-term share price movement, which Chris sees as a definite advantage.

However, he adds that while this longer term, business owner-oriented approachcan yield very good results, investors can become impatient during long periods of underperformance.

This disconnect can cause discomfort with some investors, which may lead them to buy or sell at the wrong times, which may be detrimental to their returns,Chris says.

But the nature of contrarian investing means investors often own companies that are unpopular and, at times, receive less favourable coverage in the media. However, for many investors, its difficult to own businesses of this nature, particularly when their share prices are often under pressure.

As such, Chris says a contrarian approach is counter-intuitive from a behavioural perspective, as it requires a strong and disciplined approach to investing.

So, in a perverse way, contrarian managers do what many investors know they should do doing, but find it too difficult to do,he says. Adopting a contrarian approach will invariably lead to a very different looking portfolio, but one thats focused on the preservation of capital. Investing in companies with a margin of safety in the share price is the best way to minimise risk. Its the price that you pay that matters.

Its a view supported by Lukasz: Contrarian investing can provide diversification to a portfolio by giving investors a different type of exposure to the market, particularly in a momentum market. However, the main disadvantage of going down the contrarian investing path is that it can take an extended period of time for investments to come to fruition.

This means you might go through a number of years where your investments look quite ugly against the market. So, its definitely a long-term strategy, requiring patience.

Style biases

Some investment managers believe it is best to avoid style biases (like contrarian, growth and value), arguing that different investment styles tend to outperform at different times.

And while it’s true that certain managers do perform better under different market scenarios, Chris believes that although contrarian investing is more closely linked to a value investing style, it is able to outperform in many market environments.

Managers that exhibit a growth bias invariably prefer companies with superior earnings growth, whereas traditional value investors often invest in perceived stable businesses with strong earnings and dividends and, most commonly, a P/E ratio of less than the market,he says. 

Most managers stand for something. So, regardless of style bias or output, I do think that managers and financial planners should give little credence to the broad market as their starting point for portfolio construction. Companies should be selected based on upside and opportunity, as opposed to being solely a significant part of the market.

Lukasz agrees, adding that if multiple managers with varying styles are going to be used in the portfolio construction process, then this diversification can provide a smoother ride for clients over market cycles. But he cautions that each manager chosen should be capable of delivering meaningful outcomes to the investor.

Its a view shared by Chris: If you are going to use more than one equities manager, then you should ensure they are both highly capable of beating the market meaningfully and are considerably different from one another, so they are able to smooth the ride for investors through cycles.

Negative correlation

In terms of asset class diversification, Chris says the established theory that investors should look at combining negatively correlated assets such as bonds and equities is sound. However, he adds that the problem with this is that valuation is often ignored in the process. 

If you consider the idea that interest rates are at record lows, then buying long-dated fixed income, regardless of correlation with equities, seems like a bad idea to me. Fundamentals and valuation should be at the heart of any asset purchase, as should be the time use of money,he says.

Exposure to multiple asset classes will keep clients invested in more challenging times, as diversification of low or negatively correlated investments does help keep investors on the bus. However, their returns will likely (in an absolute sense) be lower in the long run than they would have perhaps received if they had invested with a strong equities manager.

A different approach

Ultimately, a contrarian approach to investing is a very different approach for investors to adopt. So, does that mean its an approach to investing that planners should be considering for their client portfolios?

Chris believes so: A contrarian approach allows access to a part of the market that represents great opportunity from a valuation perspective. This then has to equate to better-than-average results over the long-term, as well as diversification. Otherwise, whats the point? Owning companies that are experiencing problems is difficult to do and results in a portfolio that is very different to most.

He adds that the main consideration for a planner is to understand that this is a long-term approach to investing that does require discipline and some intestinal fortitudefrom the investor. 

Its difficult being different,he says. Planners need to philosophically think that this is a sound and logical way of investing. This will assist them and their clients to stay the course through difficult patches.

Lukasz agrees: Whether conscious or unconscious, quite often you will find portfolios that are skewed to a part of the market that has done really well in recent times. Weve seen that recently in the momentum-driven market, where growth has done well. But market environments do change and things that may have worked well previously, may not work as well in the future. Thats why planners need to ensure their clientsportfolios are well-diversified,he says.

Contrarian investing does add an element of diversification and will bring something different to investment portfolios in the types of exposures clients are getting. But it is a long-term approach.

Understand the market environment

Given this disciplined approach to investing, how do planners apply contrarian investing consistently when investing for the long-term?

Lukasz believes there are two approaches planners can take.

Firstly, build a well-diversified portfolio, with different types of strategies and styles. This means that over the long-term, through different market cycles, investors have different parts of the portfolio working for them.

Thats probably the most common approach, because youre not trying to time the market or work out next years win,he says.

Secondly, he suggests that planners can also try and better understand the market environment. For example, Lukasz says in a bull market, contrarian investing doesnt tend to do well, compared to growth or passive strategies. Instead, contrarian investing tends to perform better in an early stage recovery following a dip and pull backin the market.

Importantly, with contrarian investing, investors need to understand that there will be periods where their investments will underperform the market. So, it’s a different type of strategy but its a complementary approach to high momentum or growth-orientated strategies.

Investor opportunities

When it comes to Allan Grays largest positions, Chris says it is energy-related companies, such as Woodside and Origin Energy, as well as some exposure to other cyclically-challenged sectors, that make up these holdings. 

Its fair to say that we often find value in sectors that have been or are going through a tough period, which is not to say we buy them all,he says.

As it applies to commodity companies, this often occurs when the dynamics of supply and demand lead to a change in the price of commodities, such that profitability declines and capital investment dries up.

He points to Newcrest and Alumina as examples, which have also been long-term holdings of the business.

Metcash has also been part of the portfolio for a long time, due to increased competition from abroad and price wars among food retailers. And in more recent times, we have built positions in Telstra and AMP,” he says.

This sort of approach will result in a very different portfolio as compared to the average Australian equities fund, but its this difference that means contrarian investing can make a meaningful difference to clientsreturns over the long-term.