By Margin of Safety Equity Research
It is difference of opinion that makes horse races- Mark Twain Quote
Over at www.contrarianism.net, author “The Contrarian” writes: “Perhaps the single best explanation for why the vast majority of people fail at the game of life is the Lemming Factor. This physiological disorder is named after a small rodent that migrates in large groups and has been observed committing mass-suicide by jumping over Norwegian cliffs. This species is driven by a strong biological urge to go along unquestioningly with the herd, leading to potentially dangerous or fatal consequences.”
We are programmed biologically to find comfort and safety in following the crowd. In school, we are taught to follow certain rules and in our peer-groups and communities, socialized to conform. In some respects, these are positive as it keeps us safe and allows us to fit into a functional society. When it comes to investing, however, following the crowd can be hazardous to your financial health. In his classic, The Intelligent Investor, Benjamin Graham introduces us to Mr. Market, a fickle fellow that at times behaves as a manic depressive; on some days demanding unreasonably high prices for shares of a given stock and on others, a demoralized Mr. Market will sell his shares for pennies on the dollar. The last three years has been marked by tremendous volatility in the Market. Caterpillar (CAT), a global leader in building equipment, has traded at $67.54 -$116.55 in the last 52 weeks alone. Granted there has been substantial macroeconomic turbulence with the budget battles in the US, Japan’s nuclear disaster, the credit rating downgrade of the US, and Europe’s debt woes but, is it possible for the intrinsic value of a financially strong, “wide-moat” company to shift so violently? More importantly, is it possible to profit from this market volatility?
Buying unpopular stocks with declining prices and staying away from popular “glamour” stocks captures the essence of contrarian investing. Contrarian investing seeks to take advantage of market inefficiencies and crowd behavior amongst investors. Overestimation of risk and the “fight or flight” instinct that we all share can cause an external event to result in a herd of fleeing investors. Compounding the inefficiency is the unwillingness of institutional money managers to stray from their peers due to “incentive bias.” The old adage on Wall Street, “noone was ever fired for buying IBM”, still holds true today, although you can probably substitute Apple for IBM these days.
For those with the self-awareness, preparation, and patience to seize upon these opportunities as an entry point into a stock, this can make for a great investment opportunity. Warren Buffet is a quintessential contrarian. Considered as the most successful investor in the world, Buffet’s investment philosophy revolves around purchasing cheap stocks of good companies and in the fact that Mr. Market has a tendency to overshoot with pessimism. Two good examples are his legendary purchases of American Express (AXP) and the Washington Post (WPO).
American Express (AXP)
In 1963, American Express was burned by its involvement with Allied Crude Vegetable Oil of New Jersey, by providing credit based upon the inventory of the company’s soybean-based salad oil. It turns out that the inventory, kept on container ships apparently full of salad oil, was junk as the containers were mostly filled with water and had only a few feet of salad oil on top. Since the oil floated on top of the water, it appeared to inspectors that these ships were loaded with oil. When this criminal fraud that came to be known as the “Salad Oil Scandal” was exposed, American Express lost nearly $58 million, close to $450 million in 2011 dollars. The loss wiped out most of AXP’s equity base and Wall Street pummeled the stock, which dropped ~50%. Warren Buffett took the contrarian view that, although this scandal cost AXP a lot of money and wiped out its equity base, its durable competitive advantage and cash-flow generating capabilities were intact. Buffett bet 40% of his investment partnership’s capital on AXP and, after a few years, the stock recovered and Buffett’s bet paid off handsomely.
Washington Post (WPO)
Buffett started acquiring the stock in 1973 after the stock and the media sector had taken a beating. At a market capitalization of ~$80 million, Buffett believed that there was a huge margin of safety given that he thought the company was worth $400-$500 million. After accumulating shares in the Company, the stock dropped another ~40%. This would have led most investors to run for the hills and cut their losses. Buffett, however, saw this as an increase in his margin of safety, continued to acquire more shares and history tells us that Buffett made a fortune on this stock
The key difference between Buffett and those on the other side of these trades is clear. These were absolutely untouchable stocks to most. They had lost investors money, they had made tactical and strategic missteps, or they were in unfavored industries. Can you imagine what institutional money manager would have bought these stocks when Buffett did? If CNBC and SeekingAlpha.com existed back then, can you imagine how these stocks would have been portrayed? Risk-averse institutional money managers wanted nothing to do with these stocks and commentators of the day scorned them.
Contrarian investing involves a completely different thought process and an inherently different definition of risk. Buffett thought first and foremost about the long-term franchises of these companies. In the case of AMEX, Buffett saw the Company as having a tremendous monopoly, or “toll-bridge” for countless business transactions. In the case of the Washington Post in this pre-Internet era, Buffett saw a tremendous consumer monopoly of information.
The housing and the dot com bubbles were examples of Mr. Market’s extended mania, and many within the investing public participated in this bubble. The Nasdaq, the S&P 500 valuation in 1998 was PE 40 and any fundamental analyst should have noted that valuations for the majority of stocks were not aligned with the future cash flow generating capabilities of the underlying companies. It is not simple 20/20 hindsight that any serious investor with knowledge of history should have seen the danger. Contrarian investors are skeptical of collective market investment behavior and take advantage of irrational exuberance. Buffett said it best, “be fearful when others are greedy, and be greedy when others are fearful.” Buffett not only shows opportunistic buying, he knows when to sell or stay out of the Market. When, in 1969 Buffett thought that the entire Market was overvalued, he dissolved a profitable investment partnership and returned all of the funds to clients. This disciplined policy lowers the risk of losing capital and is a testament to Mr. Buffett’s temperament and ability to stray from the crowd. According to the study conducted by Morningstar, it was found that during the period between 1994 and 2009, purchasing out-of-favor stocks outperformed the S&P 500 with average annual returns approximately 2% point higher. Moreover, those funds which purchased stocks which were most “popular” suffered had returns which were 1.5% points lower than the market average. Newer empirical data from the Brandes Institute, titled “Value versus Glamour Revisited: Historical P/B Ratio Disparities and Subsequent Value Stock Outperformance” provides additional evidence that using contrarian-based methods of selecting stocks based upon “cheapness”, in this case low price to book value multiples, yields superiors returns. The Brandes Institute looked at a basket of nearly 2700 stocks between 1968 and 2008 and divided them into deciles based upon the P/B ratio. The researchers found consistent outperformance of “value’ stocks (decile 1) compared to glamour stocks (decile 10). Outperformance of the value group was usually in the 20-40% range. When the P/B disparity between the deciles was the greatest, the following 5-year outperformance was at its greatest.
The article can be found here:
http://www.brandes.com/Institute/Documents/Value%20vs%20Glamour%20Revisited-PB%20Rations%20Non-US%20112009.pdf
In conclusion, contrarian investing is not the only viable investment strategy and it carries the risk of jumping into value traps. However, it has proven to be a profitable policy if properly adopted. A person should not just be cynical of popular stocks and aimlessly avoid being part of the crowd, as this can result in missed opportunities. But a healthy dose of skepticism, the ability to think critically, and willingness to be observant and try to find reasons why certain stock is unpopular can lead to tremendous investment opportunities. Collectivist investing carries risk. One would think that following the crowd is safe, but tell that to the lemmings!
