What a contrarian investor looks for

Photo of James Williamson, Wentworth Williamson By James Williamson, Wentworth Williamson

min read

Current opportunities seen in underperformed small industrials

Since the US election the S&P/ASX 300 Accumulation index has posted robust growth but the performance has by no means been broad-based across all sectors, as can be seen from the chart below.

Source: Wentworth Williamson

The strong momentum rally has been propelled largely by banks and companies with meaningful exposure to iron ore.

In our opinion, from current share price levels the downside risks for Australian banks and iron ore miners completely overshadows any upside potential over the next few years.

As for the banking sector, we do not have a sense of what normal defaults in the housing market will be in a rising interest rate cycle, and history may prove to be a poor guide as the consumer has never accumulated this level of indebtedness at such low rates.

We cannot guess the timing of cycles but history makes us believe there are cycles. Surely the cycle of rising house prices and the gravy train of cheap debt cannot go on forever.

With iron ore, it is always difficult to predict where a commodity price will be in a few years. We acknowledge we did not buy into this opportunity early last year, but short-term macro/commodity calls are not our game and we are not short-term traders.

As bottom up, contrarian investors, we believe the opportunities going forward are in sectors that have recently underperformed, in this case small listed industrial companies.

Our view is that investment success cannot be achieved by “following the pack”. We resist crowd psychologies, regularly finding fertile ground for new investments in unpopular sectors and unloved companies that we believe offer good value in view of the business’s potential over the long term.

Benchmark unaware

Indices (such as the All Ordinaries) may be useful in comparing investment returns, but contrarian investors do not use benchmark equity indices as a tool for active portfolio construction. Securities are selected on their individual merits, not simply because they represent a certain weighting in an index.

The investment process is focused on identifying companies we believe will deliver long-term outperformance and not on managing short-term volatility versus a benchmark. The contrarian approach may, therefore, underperform the securities markets in the short to medium term.

Identifying value is the key

Contrarian investing believes an entity's underlying value (intrinsic value) can, with thorough analysis, be estimated. This view is typically based on the experience that security prices fluctuate far more than the underlying values of the businesses they represent in the short to medium term.

This approach believes that that securities can, at certain times, be purchased at a discount to their intrinsic value because of several factors. These may include macro market issues generally, management changes, country-specific issues, a market view that the business model is broken (at least in the short-term), lack of sell-side research due to size or free float, and more generally, short-term negative investor sentiment.

Picking up pennies in front of the steamroller?

Is the contrarian approach always correct? No investment method is guaranteed. Each company presents a unique set of risks to review and some risks, such as fraud or legislative change, are very difficult to assess and can be very damaging to a company’s prospects.

Wentworth Williamson historically invests in about three to five new companies a year, as our approach is more akin to a private equity player in the listed market with low stock turnover and a concentrated portfolio. We take a three-year view rather than a short-term trade, based on the intrinsic value of the company.

We have two areas of speciality. First, we seek out companies that have issued profit warnings, performed poorly and have preferably embarrassed investors so much they do not want to remain shareholders, almost at any price.

However, should the fundamentals and intrinsic value of our target suggest substantial upside, we will happily start accumulating a position, especially where there have been appropriate management changes. We get even more excited when market commentators are overwhelmingly negative and hedge funds have already accumulated a meaningful short position late in the cycle.

The average hedge fund manager is also well-educated and experienced but our investment horizon is longer than theirs and late in the share price down cycle they will be thinking about covering the short position by buying back stock. We want to increase our position before this happens, but always where we have already taken a view on the intrinsic value of the company.

Second, we love investing in some under-the-radar, undiscovered gems, either because the market capitalisation is too low for the average institution, the story is too boring or the free float is too low. We don’t mind investing alongside large family holdings provided they intend to remain long-term shareholders.

The technology services group, CSG (ASX Code: CSV), is an example of a typical Wentworth Williamson investment

(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article.)

Source: ASX

The chart above shows the share price has collapsed in recent times, offering investors an opportunity to gain exposure to the company at a price we consider below fair value.

The upside of negativity

Many retail investors and smaller growth-orientated funds have exited the CSG register on masse, market commentators have followed the share price down with their valuations (as they normally do), and hedge funds have accumulated a significant short position at the time of writing. Negativity prevails for now. This is the type of scenario Wentworth Williamson looks for.

We believe the share price collapse is an overreaction to the company not hitting short-term earnings guidance. Short-term sales for traditional legacy print equipment and hardware have been weaker than expected; we think some of the transactions may only have been delayed and may fall into the next fiscal year.

At the same time, the earnings decline has been exaggerated because the company continues to invest and build its annuity technology with a service offering by recycling and strengthening its sales staff. This time around, CSG is more than a margin recovery story.

The business has developed a unique customer offering that is disrupting traditional sales channels. This will provide a significant tailwind for the business over the next few years and it appears it is being completely ignored by the market.

Contrarian investing can be an appealing concept but it requires expert analysis skill, a long time frame and conviction in your views.

About the author

James Williamson is a fund manager at Wentworth Williamson, a boutique value fund manager.

From ASX

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