Contrarian Investing (Part 3) – My Own Personal Experiences

Monday, December 14, 2009

575676_financial_As a final piece on contrarian investing, I thought some of my own personal experiences would help. I have selected a diverse list to show how there are many ways to gain from contrarian investing. I put in extra details, so you can get a better sense of both the environment at the time and how the decision was made.

In 1973, I left for New York City with my new MBA in hand. At the time, I had almost ten years of stock investing experience, three years working with investors as a broker and loads of knowledge from my readings and research. However, contrarian investing wasn’t discussed as a tactic – indeed, investment styles weren’t even a concept then. Just risk and return. But I did know that following the crowd was not the route to investment success.

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The darkest days can offer outstanding opportunities

In late 1974, the mood was terrible, especially in New York City. There was widespread talk of a worldwide depression coming. The severe bear market, going on two years, had taken the Dow Jones Industrial Average down 45%. Everything seemed to be going wrong.

Reading Business Week, I found a short interview buried in the back pages. (I have as yet not found it again, but the words burned a place in my memory.)

An ultra-wealthy European private investor gave a rare interview because he felt he could help people stop and think. The Business Week interviewer did his best to extract worry – indeed, panic – from this wise investor. Instead, the investor kept saying, “yes, but…” giving another, more positive, slant to a topic. Finally, in exasperation, the interviewer asked the big question: “Don’t you think we could be headed into a global depression?” The answer was perfect contrarian investing: “Yes, certainly there is a chance of that happening. However, values are so attractive right now, I am doing a little buying.”

This comment, “I’m doing a little buying,” was so surprising (shocking) to me at the time that I continue to use it as the perfect contrarian example. The market bottomed about the time of this interview.

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Ignore past performance

International Paper’s sizable pension fund contribution was about to go to Endowment Management, the fund’s best performing equity manager for 1975. Their higher quality portfolio had outperformed Capital Guardian’s riskier one, so it seemed natural to assume it was the better manager and should get the money.

However, I had developed skepticism about using past performance to make such judgments. So, I put together a fundamental analysis of each manager’s portfolio. (As far as I know, this was the first use of “portfolio characteristics” to analyze a manager’s portfolio.) What it showed was that Endowment Management’s portfolio was indeed high quality, but fully priced. Capital Guardian’s showed its risk characteristics, but looked to be attractively undervalued.

Based on this analysis, I was able to convince management to split the annual contribution between the two managers. As luck would have it (and there is always luck when it comes to timing), Capital Guardian immediately began a lengthy period of significantly outperforming Endowment Management.

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Even institutional investment managers can get it wrong

It is early 1994. Tobacco stocks have been drifting lower since late 1993 on worries of political actions and generic brand inroads. And, there was always the overhanging risk of a successful lawsuit. As a result of good valuations, all of our five Liberty All-Star Equity Fund managers, from deep value to fast growth styles, now owned tobacco companies. We heard versions of the same story from each – sound fundamentals, attractive valuation and excellent growth prospects. The worries were downplayed because tobacco companies had successfully handled politicians and lawsuits in the past; plus, brand identification was felt to be very strong among users.

The logic kept nagging at me, especially since the stocks kept drifting lower. In late March, I realized the problem: the tobacco industry was not a integral part of the economy – it stood alone, without widespread political or industrial backers. Therefore, I thought the stocks carried greater risk than was generally believed. The fact that all our managers owned the stocks confirmed it to me.

Although I always believed in giving the managers full discretion, I decided to ask all of the managers to sell. As luck would have it (again!), the bad news struck the next week on April 2, showing the companies were not invincible and driving the stocks down over 20% in one day.

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Powerful trend changes offer highest rewards

In late 1998, I added the Vantagepoint Growth & Income Fund to the fund lineup. It started with two investment managers: Capital Guardian (growth from value-priced stocks) and Putnam Investments (risk-controlled growth). From its inception, the fund beat the Standard & Poor’s 500 Stock Index (S&P 500) every quarter. Then, in the fall of 1999, the growth stock run-up began in earnest. While the fund continued to do well, I worried about what would happen when the trend changed.

Three items led me to make a contrarian investment move. First, the term “new economy” was born, implying that what we were seeing was sound, not a fad. Then, investors began to trade wildly, expecting to earn extraordinary gains. Finally, The Wall Street Journal quoted an analyst, who said the US economy no longer needed “old economy” companies, like International Paper. To me, that was the sign we were near the top.

After a search, we found Jack Ryan at Wellington Management, an excellent value manager. Not surprisingly, we were the only institutional fund manager showing any interest in Jack and even value investing at that time – another contrarian sign that we were on the right track. We added Jack, giving him a third of the portfolio. As luck would have it (!), this was March 2000, the peak of the growth bull market and the beginning of the value one.

At that point, the Vantagepoint Growth & Income Fund had surpassed the S&P 500 Stock Index in each of the preceding six quarters. In the post-March 2000 period, the fund went on to beat the S&P 500 in each of the following seven quarters – 13 quarters of outperformance, leaving the fund ahead by over 40%.

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To summarize, contrarian investing is a powerful strategy for any investor. Always running with the herd can produce losses, missed opportunities and emotional turmoil. I have seen many fads and fears ruin sound long-term investment programs, for both individuals and institutions.

It takes practice to buck the trend successfully, but I believe it can be done by anyone. My postings here in often address items I believe are being misinterpreted, over-popularized or under-appreciated. These are the ingredients needed for successful contrarian investing. I expect you will read some (many?) of my posts and say, “Whoa! That can’t be right!” At those times, I hope you will read my comments again and give them some thought. If you are using a financial adviser, ask them about the subject. If you are an independent investor, force yourself to think twice.

Tomorrow, back to current events…

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