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A guide to contrarian investing

Does contrarian investing really work? CastlePoint Funds Management explains the process and what is required to succeed.

Tuesday, September 17th 2019, 6:00AM

by Castle Point Funds Management

It is an often-heard cliché that to beat the market you need to be a contrarian. But what exactly does this mean, as it implies that the market is, if not always wrong, wrong for a great deal of the time? How can that be?

Going head to head with the market every day on every security is surely a losing game. Continually buying the stocks that are down and selling those that are up will generally end you up in the poor house. To be successful a contrarian investor must be selective and patient, essentially picking their battles. And make no doubt about it, making profits in the share market can be an epic battle of emotions.

Here is an apt analogy that we have come across. Imagine that you are in a cinema when a fire starts, and you have two minutes to get out. The only sensible decision is to exit as quickly as possible. The contrarian investors that rush into that burning cinema do not beat the market, they are toasted. So clearly that type of contrarian activity is not a winning strategy. That strategy would work if the cinema was not on fire, but surely the market does not panic and stampede when there is no fire?

Wrong.

The market is very sensitive to fire alarms and regularly panics at a whiff of smoke or peal of a siren. This is human nature and highly understandable, nobody wants to get burnt. It does however create overreactions to false alarms where a contrarian investor can buy a quality business on a “glitch”. This is not an easy activity and the contrarian investor needs to have strong conviction to go against the majority and buy on bad news, but it can turn out to be a highly lucrative strategy.

A good example of this was the price action of Afterpay in October last year. It has been a good performing business, experiencing very high revenue growth and a rapidly escalating share price. But is has not been a smooth ride. October last year was a highly volatile month in global share markets and, using our cinema analogy, patrons were getting very twitchy about potential fire hazards. At an overall market level there was more selling than buying and share markets around the world were retreating. And then on October 15 a report hit the wire that suggested an Australian Senate inquiry into the Afterpay business was underway. The Bloomberg headline referred to the report as “A Hint of Trouble”, however a decent chunk of the Afterpay moviegoers thought they smelt smoke and stormed the exits. The Afterpay share price fell 19% on that day and was to fall around 40% in total in the ensuing sell off. At the time it demanded significant conviction to go against a virtual stampede of selling and have the patience to consider the actual substance of the news which, in our opinion, clearly indicated a false alarm. Any contrarian investors that decided to head into the cinema during this alarm are today potentially sitting on somewhere between 150% and 225% gains.

Contrarian opportunities also exist in what is termed “value” situations. These are companies that are out of favour and have been serial disappointers. Often these companies have seen their share prices drop significantly, falls of over 90% are not uncommon. Clearly these companies had a genuine fire alarm and any contrarian that decided to rush in got duly toasted. The market got those right. The market is less good at acknowledging when the fire has been put out and repairs are well underway. This is not unreasonable behaviour, avoiding dangerous situations is a hard-wired instinct that generally serves us well in life. In the cinema analogy, the cinema might need to offer attractive deals such as two-for-one ticket deals and buckets of free popcorn to attract customers back.

A prime example of this type of situation is Macmahon Mining Services. Looking back to 2010, the share price was around 60% off its recent highs. The cinema had been emptying rapidly, but the fire was still burning and investors that rushed in were destined to lose over 90%. By anyone’s definition, that is buying a value opportunity far too early. It was to be another five years before the company had dealt with its problems and was an attractive investment. But to lure investors back the share had to trade at 5c or less. Owning Macmahon at that point was akin to getting a family movie pass for the price of one ticket. However, very few investors were keen on this deal because they still had clear memories of the nasty fire a few short years ago. It was only contrarian investors that were interested in the special offer, having assessed that fire was no longer a realistic concern.

Being contrarian for the sake of it will get you in a bind, the market is by no means wrong all the time on all the stocks. However, patient and disciplined contrarian investors can find great investments. Two prime examples are the false alarm and the completed rebuild. The false alarm is the chance to buy growth companies that have a temporary glitch at attractive prices. While the completed rebuild is the opportunity to buy recovering companies at bargain prices. Neither is easy though, as the contrarian investor requires the conviction to go against the market and risk looking foolish in the process.

 

Disclaimer: The following commentaries represent only the opinions of the authors. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest. All material presented is believed to be reliable, but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Castle Point Funds may or may not have investments in any of the securities mentioned.
Product disclosure statements, issued by Castle Point Funds Management Limited, can be found at www.castlepointfunds.com/investor-documents

Tags: Castle Point Commentary investment Markets

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