Uncovering the hidden opportunities

19 April 2022

Money & Life team

Money & Life contributors draw on their diverse range of experience to present you with insights and guidance that will help you manage your financial wellbeing, achieve your lifestyle goals and plan for your financial future.

Contrarian investing provides an effective way to diversify your clients’ portfolios and manage their risk. However, this type of investing requires a long-term focus, patience, and good communication skills with clients. Here we talk with two financial planners about their experiences.

Contrarian investing is an investment philosophy where analysts conduct in-depth research to uncover opportunities in shares that have been overlooked or discarded by the broader market. This often means purposefully going against prevailing market trends; they buy undervalued shares in a less optimistic environment, then sell when the outlook improves, and the share reprices. It is a disciplined, long-term approach to investing, requiring patience while contrarian investors wait for the market to recognise the value they have identified.

By going against popular trends in the market, contrarian investors face less competition and can pay a lower price for shares that are out of favour with the broader investment community. Paying a lower price increases the chances of achieving a better than average return over the long term.

Contrarian investing can result in very meaningful differences in portfolio holdings, potentially delivering investors better returns than the broader market over the long term. Why? Because if you buy and sell the same shares as the majority of investors at the same time, it is almost impossible to outperform the market.

While holding out of favour shares can be uncomfortable for some financial planners, others see it as a great opportunity.

Just ask Peter Bailey CFP®, a Financial Planner and Chief Investment Officer at Planning Partners. For Peter, contrarian investing is all about the opportunity to diversify his clients’ portfolios and therefore reduce risk. Planning Partners added contrarian investing to their portfolio of funds about 10 years ago.

The business uses five or six different managers, including growth and value managers, in its Australian share portfolio.

“Since Planning Partners started in 1999, it has always had value funds on its recommended list. It’s an investment strategy that we can get behind,” he says.

It’s a similar story for Tim Scott CFP®, a Director of Ford Scott Financial Planning. He explains that his firm uses a three-bucket investment approach.

The first is an appropriate cash reserve bucket, which depends on the life stage of clients – for example, whether they’re accumulators or retirees and the liquidity buffer they need, given their situations.

The second is in its core asset approach. Here it employs external professional support for the asset allocation and construction of its core portfolio and participation in the firm’s investment committee. This ensures tight risk management frameworks are in place and dynamic asset allocation supports this.

Finally, there is a so called satellite bucket, where it looks to determine a thematic portfolio that is best suited to perform in a certain market cycle.

“That satellite bucket will be larger or smaller depending on where we are in the cycle. From our perspective, contrarian investing is part of that,” says Tim, with the firm allocating between seven and 10 per cent of its clients’ portfolios.

“For us, contrarian investing is about the importance of not always following the herd, especially as the market cycle changes,” he says. “Instead, it’s about tapping into parts of the market that are less crowded.”

Sticking to the knitting

Tim believes that when it comes to contrarian investing, it is very important that advice businesses work with managers that are committed to contrarian investing and have a proven track record in taking contrarian positions.

“Some managers are sometimes not true to label and will feel the pressure to conform to what the markets are doing, rather than trusting in their conviction and philosophy,” he says. “That’s what attracted us to Allan Gray as a contrarian manager. They have a history through cycles to follow their disciplines including periods where it may underperform, compared to growth investments.

“We would say as an investment manager, Allan Gray is very disciplined, and it doesn’t sway from its approach when the going gets tough – and the going often does get tough.”

Tim says his firm explains to clients that it expects volatility to be potentially smoother in the core bucket of investments, but that longer-term returns may be more constrained in this bucket.

“But in our satellite bucket, we are trying to source outperformance over and above the core returns. We have Allan Gray as our sole contrarian manager, but we also have one global growth manager and also one style neutral manager too,” he says.

Not for everyone

Peter and Tim both acknowledge that contrarian investing is not for every client and can be uncomfortable for some. This is because a contrarian manage will hold shares that are out of favour with the market. Investors need to be comfortable with being different.

But they also agree that taking a contrarian approach can improve the chances of paying a lower price for a stock and therefore, achieving a better-than-average return. It also helps avoid speculative overoptimism, where stock prices rise too high, thereby reducing the risk of overpaying. If overoptimistic stocks are priced for perfection and the outcome is only ‘good’, the price can fall significantly.

Peter explains that both contrarian and value managers look for stocks with share prices below the intrinsic value of the company and which are mispriced because of the prevailing market sentiment.

He adds: “A contrarian manager could buy a stock with a higher P/E multiple or something that would normally eliminate it from a value fund. It might be that the market doesn’t like the stock because there’s been an event or something else that’s caused it to be oversold.”

As an example of a global contrarian stock, Peter cites Volkswagen, which was very heavily sold off in 2015 because it had been untruthful about its emissions tests in the United States. In the scandal’s first two months, the company reportedly lost 46 per cent of its value, and the damage to its brand and reputation was immense.

“That’s an example of an event that’s going to cost a company a lot of money. But the markets overreacted. In the cold light of day, a contrarian manager would have stepped in with the facts and figures and bought some of the stock, because it still found value in the company.”

Indeed, when a stock is priced for disaster and the outcome is only ‘quite bad’, the price can rise considerably.

Tim explains that most managers invest according to macroeconomic conditions and focus on sectors and trends. After that, they will select stocks based on their in-house disciplines.

“Inevitably, the macro environment goes through periods of sustained growth, where assets become overvalued and the more opportune stocks get lost,” he says.

A contrarian manager, on the other hand, will focus on identifying individual companies that appear under-priced, rather than on macro trends. After that, the manager will conduct its internal analysis of a company and carefully assess a range of potential outcomes throughout the cycle.

Peter notes that the past five years have been tough for value and contrarian managers because of the way growth and momentum stocks have outperformed.

“There can be periods of underperformance, compared to the wider market, for quite some time,” says Tim. “But we’ve noticed in recent times of volatility that Allan Gray’s conviction to some of the stocks it has held have suddenly come to fruition.”

Tim says his clients are pragmatic and understand that some managers will do particularly well at certain periods and not so well at other times.

“What’s important here is to look at the rationale for using a contrarian manager. I think a long-term manager that is prepared to look for higher returns brings genuine diversification to a portfolio,” he says.

“We want managerial and style diversification and to achieve this we use three managers, of which two are SMA’s, in our satellite bucket. And they all do things differently. The whole aim is to give enough breadth and have enough conviction to get the portfolio outcome we need.”

Investing in a fund like the Allan Gray Australia Equity Fund also requires a long-term investment horizon, and clients need to be aware they will need to be patient and take a long-term approach. This is where good communication skills from the financial planner are necessary.

“Clients who prefer to move with the market will sometimes struggle to understand what a contrarian manager is doing, but the whole point is that a contrarian fund is designed to be very different to the general market. Especially in periods of very strong markets when the fund could perform relatively poorly,” says Peter.

Communication is key

“It’s on us – and me – to educate our clients about why we use a contrarian fund,” says Peter.

When he invests a client in a contrarian fund, Peter ensures he spends time with the client to set expectations around what the fund can do.

“After that, you educate the client through the process because when the numbers are all over the place, they might be asking for an explanation about why we’re using the fund,” he says.

“It’s about demonstrating what a growth manager does and what a contrarian manager does. So, at the moment, you might demonstrate the growth manager’s five-year track record, which looks fantastic, compared to Allan Gray’s, which currently doesn’t compare as well. But then it’s about talking about what the reversal of that situation would look like and how you blend funds together to smooth out returns over time.”

Tim agrees: “It’s all about explaining to the client what the investment philosophy is, the structure, the risk management framework, and what the underlying managers are trying to do.

“It does make for a lot more constructive and productive client conversations at review time. Then we can start focusing on our clients’ needs and their strategies to achieve their goals and objectives.”

However, Peter concedes he probably wouldn’t’t use a contrarian fund for some of his very conservative clients.

“All our portfolios are bespoke,” he says. “So, it does depend on the client. Sometimes it also comes down to how experienced clients are with investments. More experienced investors are likely to better understand this approach to investing.”

He adds: “To be honest, we don’t get a lot of pushbacks from clients. Most clients are not particularly interested in the names that sit in the portfolio. So, Allan Gray is not a fund that I have to sell per se. But you do tend to get more queries about a fund like this one, than one that rattles along with the rise and falls in the index. However, once you explain what contrarian investing is and why you are using a contrarian fund as part of their investment strategy, then people become generally comfortable about this investment approach. They acknowledge they’re paying you for the advice.”

Tim has similar views.

“From my perspective, clients won’t focus on the one manager. They focus on things like good diversification, but they understand and have conviction in why we’re investing in certain managers,” he says.

“And that’s where the trust comes. I think talking to clients about just one manager is dangerous. Our clients are trusting us to build a portfolio that’s going to meet their goals and objectives over a 10 or 15-year period.”

The tide may be about to turn

Peter accepts that over the past 10 years, in particular, the market hasn’t always gone the right way for contrarian managers.

However, the Allan Gray Australia Equity Fund has outperformed the S&P/ASX 300 Index over that time.

“That’s a function of very low-interest rates and extremely easy money. That’s when index funds, start-ups tend to do okay. But you have got to look at it in the context of the market and I think what it says to me is that now is probably a pretty good time to be adding money to a contrarian fund.”

However, the bottom line, says Peter, is how shares are priced in the first place.

“That’s where a firm like Allan Gray can be quite valuable because it hasn’t overpaid for stocks,” he says. “Another thing that I have seen with Allan Gray that I haven’t necessarily seen from other managers is that it gets quite involved with the management of the companies it invests in. I do like the fact that it gets quite active in the businesses it invests in.”

Like any investment, contrarian investing is not right for every investor. But for clients who are patient and disciplined, and who are prepared to invest for the long-term, contrarian investing can provide clients with great diversification for their portfolios, whilst also allowing them to better manage their risk. It’s an investment approach worth considering as part of the portfolio management process.

 

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