The other way

Fund Strategy - 2 Jul 2012 | By Helen Burnett-Nichols

In an investment environment driven by broader political and economic concerns rather than company fundamentals, choosing to go against the crowd has been a tricky approach for some managers over the past four years.

While virtually all managers have reported difficult investment conditions since the 2008 financial crisis, many who prefer a contrarian style explain that increasing short-termism in the market has made their jobs more challenging.

Although some contrarians say they are spoilt for choice when it comes to finding good-quality, undervalued companies, they remain conscious of the rollercoaster nature of many sectors, as short-term cycles of ’risk-on’ and ’risk-off’ have meant that stocks are moving in and out of favour quicker than usual.

Sanjeev Shah, the manager of the Fidelity Special Situations fund, explains: “As a bottom-up, fundamental stockpicker, a market where company fundamentals are at the forefront of decision-making in the market is favourable. Conversely it is harder to operate in a market that is very much driven by macro/political events.”

Nick Kirrage, the co-manager of the Schroder Recovery fund, says that in general the best opportunities to be contrarian are where there is a strong consensus, as opposed to a market where investors are unsure and are all using different approaches. (Cover story continues below)

As such, while contrarian managers do use several strategies and perform differently in discrete periods, many who use a classic value strategy and seek out the most unloved parts of the market have reported periods of underperformance to their benchmark or peer group within the past few years.

But at the same time several have outperformed their indices over the longer term, notes Darius McDermott, the managing director of Chelsea Financial Services.

For example, while the Artemis UK Special Situations, Fidelity Special Situations and Investec UK Special Situations funds have underperformed the FTSE 100 in the year to June 13, they all beat the index’s 9.94% return in the four years to that date.

Still, in the face of a market driven by macro influences and increasing correlation, true contrarian managers say they are sticking to their convictions that their bets will pay off with patience, even as many feel they are sitting in exclusive company in Britain as investor time horizons shorten.

“From our perspective, there is definitely money to be made being a contrarian and as people become more short term, in some respects, that’s the trade – becoming more long term is the contrarian trade and that’s where the opportunity to make money is,” says Kirrage.

Despite the launch of a few new contrarian investment vehicles late last year, such as the Luxembourg-domiciled Threadneedle US Contrarian Core Equities fund and the Investec GSF Global Contrarian Equity fund, contrarian managers do seem to be in limited company.

”A lot of people think that a lot of things could change in the interim and they’re not willing to bet on positions like that”

In its June survey of fund managers, the Bank of America Merrill Lynch noted that investors have adopted aggressively “risk off positions”, over fears of a global economic slowdown and growing expectations of decisive action by policymakers. Asset allocators, the survey says, have moved to a net underweight position in global equities and increased their bond allocations.

Even with the positive long-term performance numbers for many funds, it can still be difficult for contrarians to convince investors to follow their convictions for the long term in a market that is no longer favouring ’buy and hold’.

Tristan Hanson, the head of asset allocation at Ashburton, which has a contrarian element to its multi-asset funds, says: “Typically, investors in the funds or the investment community [are] often not patient enough to wait for an idea that might come to fruition in three or four years and frankly, a lot of people think that a lot of things could change in the interim and they’re not willing to bet on positions like that.

“But what we try to do in that case is to have a variety of positions and hope that they’re not all correlated or hope that some of them are negatively correlated.”

Alastair Mundy, the head of the contrarian team at Investec Asset Management and manager of the Investec UK Special Situations and Cautious Managed funds, says despite the evidence that it is good to buy low and sell high, people still prefer to buy high and then try to sell even higher.

“The reason for this is that buying low is very uncomfortable. You feel very lonely. It’s a bit like eating a meal in a restaurant on your own or single-handedly clapping a referee at a football match for what you view as a good decision but which everyone else thinks is disastrous,” he explains.

Indeed, McDermott says he has not seen any great increase in people wanting to call themselves contrarian in recent times.

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“Lots of people do describe themselves as slightly contrarian or ’if everybody’s walking that way, I like to walk the other way’. The actual proof of that is, are you buying the sectors that everybody else hates?” he says.

While many investors take what could be described as contrarian bets in their portfolios from time to time, the managers of several funds, such as Artemis UK Special Situations, Fidelity Special Situations, Invesco Perpetual High Income and Investec UK Special Situations, have proven their commitment to contrarian investing over many years, adds McDermott.

“They do have periods of time where they underperform. But they would say that’s probably at the time where they are making their best investments, because the market’s moved away from them into the areas that they don’t like, because they think they’re expensive or trendy. They’re buying the stuff that’s cheap but often that can take a while to kick in,” he says.

History has shown evidence of these swings, but also proof that contrarian bets can pay off. Warren Buffett has made a career and fortune out of investing against the crowd.

McDermott also points to Neil Woodford’s decision not to invest in technology, the internet and telecoms in the late 1990s and early 2000s.

While the Invesco Perpetual manager’s performance was hurt during 1998 and 1999, his choice to invest instead in solid, stable cash-generative businesses that paid a dividend, but that he felt everybody else in the index hated – tobaccos, utilities and food companies – led him to significantly outperform over the next decade.

“It’s a bit like eating a meal in a restaurant on your own or single-handedly clapping a referee at a football match”

Similarly, for some contrarian managers, bets taken in the years leading up to and following the financial crisis have proved advantageous.

Paul Mumford, the manager of the Cavendish Opportunities, AIM and UK Select funds, says: “It’s been a great time, because I could almost argue that there are too many contracyclical areas of the marketplace. If you look around for cheap stocks, you could select stocks from almost any area of the market.”

Aidan Kearney, the co-head of the multi-manager team at Aberdeen Asset Management, adds: “You find value managers buying stocks in the last six or eight months that they never thought they’d be able to buy again, because the prices have dropped back down into their range.”

On the bond side, Peter Geikie-Cobb, the co-manager of the Thames River Global Bond fund, points to the two-year period leading up to 2008, when he says it felt like no-one was ever going to buy a government bond again. During that time, in an environment of low inflation, the name of the game was credit, mortgage paper, credit default options and corporate bonds.

“We were of the view that there would be a credit bust at some point and we were focused on the core government bond markets, the Treasury market, the German bund market and the UK gilt market and the dollar as a safe haven currency, so in a sense, going the other way from the carry trade,” he says.

“I think that two-year period leading up to Lehmans the market was driven by carry trades and, of course, that all unwound in a spectacular fashion. And so, we were contrarian leading up to that, because the ultimate bust if you like, was going to benefit core bond markets and the dollar.”

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Shah explains his underweight position in miners has worked well, as mining stocks have been weak as the global growth outlook has deteriorated. Similarly, Mundy says the performance of his UK Special Situations fund in the year to the end of May was helped by the underperformance of non-gold mining stocks such as Rio Tinto, Anglo American and BHP Billiton, which he considers overvalued and does not hold in the portfolio.

Kirrage points to life insurance, which he says “got beaten badly with the banking stick” in 2008 and 2009 but are more stable, more long-term businesses in some respects and an area from which his fund has seen great returns. Specifically, he mentions Legal & General and Old Mutual, which have shown several hundred percent’s worth of positive return and strong dividend growth, as investments where his fund has done well.

Meanwhile, Russell Cleveland, the Dallas-based manager of the RENN Universal Growth Trust, highlights a contrarian turnaround investment he made in 2008 in AnchorFree, an internet company, which was trying to get venture capital at a time when nobody was interested in investing. After a change in the company’s business plan, Cleveland says it has turned into a success story, with RENN’s original $2.5m investment growing to $33m. “Stepping up and making a commitment and believing that these people will succeed has been one of the better investments we’ve made in years,” he says.

However, Mark Dampier, the head of research at Hargreaves Lansdown, says being contrarian for contrarian’s sake has not necessarily made investors money – at least over the last few years.

“I would point to bond managers who have been shorting the gilt market for quite some time and have been effectively carried out by it. So, I think there is a great danger, in the very short term, about being contrarian in a market which is being led by momentum and the trouble with momentum is it lasts much longer than you think,” Dampier says.

Indeed, several contrarian managers admit the past few years have also been marked with ’against the grain’ bets that did not work out as planned.

One of the features of the market since the beginning of the financial crisis, says Shah, is that stock level correlations have spiked significantly, with macroeconomic factors driving performance. He admits his contrarian value approach can result in significant performance differences relative to an equity benchmark in the short term.

From Shah’s perspective, one area that has not worked is financials. Indeed, the FTSE All-Share Banks index fell 14.44% in the year to June 13, compared with a 2.4% drop for the FTSE All-Share as a whole. Shahhas had about 25% of his portfolio in the financials sector for much of that period.

Still, he retains his strong belief that his investment style will continue to outperform over the long term.

“I see a great deal of upside in names like Lloyds, which has significant market share in UK retail and corporate banking yet trades on less than 0.5 times its book value. These stocks have underperformed in light of the sovereign debt crisis, but I feel that provided we don’t have an implosion in Europe, there is significant upside in certain names on a three-year view and limited downside,” he says.

Kirrage says he was likely in too early with a couple of stocks. “Banking, we were probably in a bit early, although having said that we were pretty cautious,” he says.

Geikie-Cobb is also open about the fact that he has been too early in an expectation of an upward correction in core government bond yields. However, he explains “the trade now just looks an even better one, with 10-year US Treasury yields getting down to 1.5, below 120 in Germany and so forth”.

”Contrarian managers need to take particular care of balance sheet because if you’re buying a company that is deeply out of favour, it’s deeply out of favour for a reason”

At the same time, contrarian investors continue to cite the importance of ignoring short-term macroeconomic volatility and the resulting emotion in the stockmarket and having the confidence to stick to their convictions for the long term.

“I think what’s difficult about the current environment is from a medium to long-term perspective, it’s quite clear to us what’s going on and what the end game is likely to be, but markets take a little bit longer to price that in,” says Geikie-Cobb.

“There’s always a short-term newsflow which dominates, but the contrarian long-term value investor is trying to look beyond all of that and he’s trying not to get distracted by short-term price actions and he’s trying to say look, this is a good business, it’s growing its earnings at 15% a year, I can buy it on a single-digit multiple, it’s got a quality balance sheet, it’s got low gearing,” adds Kearney.

What makes a good contrarian investor, says McDermott, is avoiding the value traps. that is, stocks that are cheap but are either going bust or set to go much cheaper.

“I think contrarian managers need to take particular care of balance sheet because if you’re buying a company that is deeply out of favour, it’s deeply out of favour for a reason. You want to make sure that company is strong enough to survive a prolonged period of being out of favour,” he says.

Indeed, Mumford says investors have to remember there are minefields everywhere.

While he favours the retail sector, noting that food retailers and clothing companies with a decent product offering look attractive, he says the fundamentals of others in the sector have changed – affected by factors like the internet or a heavy property portfolio – and may never recover.

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In the current environment, Kirrage is not looking for miracles from the companies in which he invests.

“All that is fair to say is ’look, you know, if you can just manage your business cautiously, sensibly, try and reduce the downside from stuff that is going on and make sure that there is a business that exists in three years time’, that is going to be enough, frankly, because some of these businesses are priced as if they’re either not going to exist or they’ll never make significant amounts of money ever again,” he says.

At the moment, the classic consensus trades in Britain and globally include being negative on banking, consumers – especially in the developed world – and on the developed world versus emerging markets, which Kirrage says are all driven by macro concerns.

“The other side of those trades, the contrarian side of those trades [like] banks or consumer stocks or developed markets, are broadly a lot cheaper than stocks outside of those sectors,” he says.

Kirrage’s portfolio is overweight developed world versus emerging markets, as well as high street consumer stocks and banking relative to the index, both of which he says have come back as much as they went up.

He notes that some of the British supermarket sector is becoming increasingly cheap, with stocks like Morrisons dragged down but boasting some attractive attributes, priced low with good balance sheets.

Within Britain Kirrage is also starting to dip a toe into areas like defence, which is becoming increasingly unloved as investors focus too much on macro problems rather than valuation.

For Geikie-Cobb, another current contrarian view involves the emerging investment-grade government bond markets, which he thinks is an overcrowded trade.

”At some point the crowd’s got to start believing in what we thought because if the position’s always contrarian, it tells you that it’s probably not been working at any stage”

“Investors think that because emerging government balance sheets are in much better shape than the developed world, those bond markets are quite a good place to be, particularly if they’re offering higher interest rates. The problem we have is that the currencies of all those countries are now pretty fully priced,” he says.

At the moment, Geikie-Cobb is shorting bunds, with a view that the market is expensive and will unfold in his favour in more than one scenario.

Towards the end of 2011, Shah started to find a lot more contrarian value opportunities. This is particularly in turnaround situations where a new management team has the potential to improve what is essentially a good franchise that had not been well managed in the past and had underperformed. He points to the gaming company Ladbrokes, the asset manager F&C and the defence company QinitiQ as examples.

Ultimately, whether these contrarian bets see success depends on investors eventually coming around to a manager’s point of view.

As Shah explains: “Investing in stocks that are trading significantly below their intrinsic value [and] that are unloved by other market participants can be a very profitable strategy when the market does come to appreciate the growth potential or intrinsic value of these companies.”

“At some point the crowd’s got to start believing in what we thought because if the position’s always contrarian, it tells you that it’s not been working at any stage,” adds Hanson.

Although short-termism has tested their mettle in recent years, managers that take contrarian approaches continue to strive to manage the downside over the longer term while they wait for markets to shift in sentiment. this is in the hope that their non-consensual views ultimately turn into money making ideas.

“There’s a lot of validity in contrarian strategies, it is just a question of try and find some uncorrelated strategies that will pay off on average over time and not be too volatile,” says Hanson.

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