This article appeared in the March 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Karl Siegling, Cadence Capital
The implication of so-called contrarian investing is that people invest contrary to what others are doing, or contrary to the sharemarket, or even contrary to what the mass of investors are doing. Let's look at some concrete examples, because contrarian investing is not as clear-cut as it sounds.
For example, a contrarian investor announces they are not investing in the internet bubble and are staying on the sidelines because the masses have it all wrong. The internet sector then goes up 100 per cent per annum for two years. Then, as is invariably the case, this stellar performance is followed by a tech-wreck.
At this stage the contrarian investor has made no profits from the sector. But now that everyone is selling, presumably the contrarian, acting contrary to what everyone else is doing, starts to buy technology stocks (on the way down) and proceeds to lose a substantial amount of money as prices fall further.
In another example, the contrarian does not buy ABC Learning as the price rises from 50 cents to $5.50. But when everyone starts selling, the contrarian, acting contrary to what everyone else is doing, starts buying ABC Learning and keeps buying until the company goes bankrupt. At that stage the contrarian investor has again lost a significant amount of money.
A better approach
A far more "wholesome" approach to contrarian investing would be to buy the technology sector on the way up and sell it on the way down. Similarly, in the case of the failed ABC Learning, I would have recommended a strategy of owning the stock while it was going up and selling when it started falling.
If you adopt this latter approach you are actually making investment decisions "with" the market and not "against" it - hardly contrarian investing. All this logic is contained in the many popular and instructive sayings in the market: "The trend is your friend; don't fight the market; never try to catch a falling knife; don't stand in front of a moving train; and the classic, the market is always right".
When the resources boom ended three years ago no one rang the bell. In fact it is only recently that investors are being told by industry experts and government think-tanks that the resources boom is over. The resources sharemarket boom ended three years ago.
A contrarian may have told you they had bought resource stocks when they fell 10 per cent, because they were a contrary investor. My advice when you hear this type of logic is to run a mile, and keep running from every contrarian who has ever told you they were buying the dips.
A different contrarian meaning
To be more constructive, let us try to construct a different meaning for "contrarian investor". Presume the contrarian is astute and diligently studying the markets, and trying to identify cheap and expensive stocks. It should follow that truly cheap stocks should, over time, increase in value and truly expensive stocks should, over time, fall in value.
Also assume that the contrarian investor has developed a keen sense of market psychology and is constantly on the lookout for moments in time when people, the mass investing public, or "the market", are either extremely pessimistic or extremely optimistic.
The contrarian may be trying to determine points of maximum optimism and maximum pessimism. Objectively, this may not be as difficult as it sounds. Stocks tend to get incredibly cheap during periods of maximum pessimism and incredibly expensive during periods of maximum optimism.
Here is the crux of the matter. The point, at which a stock becomes incredibly cheap and has passed the point of maximum pessimism, is probably an ideal time to buy it. At that point a potential buyer is no longer fighting the market or buying a falling stock, but has waited for complete exhaustion by the pessimists and noticed that some small amount of optimism is again appearing in the stock.
At this crucial moment a contrarian is not actually acting contrary to the market but is following the market trend or moving with the market. In the words of Jesse Livermore (the great US trader and author), the contrarian is "following the path of least resistance".
In one of life's great ironies, those investors who tend to be labelled contrarian investors spend an extraordinary amount of time making sure their fundamental research is correct and that they are not "fighting the market".
Who it suits
Contrarian investing suits patient people who have the time to wait for bull markets to end and for bear markets to end. A contrarian will wait for a stock to finish falling before buying it, or hang onto a stock until it starts falling before selling it.
Contrarian investing tends to suit people who are contrarian, but not too contrarian and certainly not contrarian just for the sake of it, or just trying to pick a fight with the market. Investors who fight the market tend to lose.
How can you tell if a stock is a genuine turnaround or just a falling knife? The easier part first: to avoid falling knives, don't buy stocks that are falling. A genuine turnaround story should have finished falling and started going up. Importantly, the best turnarounds can also usually be identified as being cheap, sometimes having been even cheaper and started to recover.
A rough rule of thumb for investors trying to pick turnarounds is to leave the first 100 per cent return to someone else. For example, a $2.40 stock falls to 7 cents and then recovers to 14 cents. Or a $4.00 stock falls to 18 cents and recovers to 36 cents. In both these examples a turnaround investor should leave the first 100 per cent return to someone else, to reduce risk.
Does technical analysis help fundamental analysis?
Technical analysis can definitely help with the basic errors investors tend to make. Errors can loosely be summarised as either buying stocks that are falling or selling stocks that are going up (not letting your winners run). An important distinction to make with the way Cadence Capital invests is that technical analysis is conducted once it has been established a stock is either fundamentally cheap or expensive.
There are a group of investors we would describe as "pure technical investors" who only use technical analysis and do not use fundamental research. Clearly, for that group, technical analysis is the only tool they have at their disposal. We believe in the advantage of using both fundamental and technical analysis to assist when investing.
Following on from earlier comments, look for areas of maximum pessimism or areas that may be approaching or may have passed the point of maximum pessimism. The type of sectors or stocks that, if you mentioned them at a dinner party, people would probably laugh at you or think you had gone mad.
For example, the bombed-out resources sector, the decimated mining services sector, Australian gold stocks, the wine sector in Australia, coal stocks, iron ore stocks. Perhaps these sectors contain stocks that could be potential turnarounds, just like the technology sector was after the tech-wreck and the financial services and banking stocks were after the global financial crisis.
About the author
Karl Siegling is Portfolio Manager at Cadence Capital Limited.
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