The lure of the contrarian trade – why sometimes avoiding the wisdom and follies of investment crowds can still deliver for investors.
“Drinking the Kool-Aid” has become a rhetorical catch-all for the dangers of groupthink and the importance of contrarian thinking. Peer pressure and emotions are fickle things but opting to avoid a herd-like mentality can actually prove to be a useful tool for active fund managers. Inefficient markets mean that simple contrarian strategies can perform well at big macro turning points. Given recent market volatility, avoiding value traps – stocks that seemingly screen cheaply but offer mixed dynamics – is crucial.
David Dreman is considered one of the ultimate contrarian investors. His work in the early 80s provides valuable insight for investors. He consistently stressed the importance of being patient and investing for the long term. Dreman placed great emphasis on the significance of analysing underappreciated assets. To paraphrase Baron Rothschild, he believed the “the time to buy is when there's blood on the streets”.
After all, valuations matter in the long run
Currently, it feels like we’ve reached that point in the market cycle where investing in a contrarian trade can be a credible strategy. There are plenty of compelling contrarian signals right now. Bearish on FAANGs?* Long retail? Short gold? Short financials? Long sterling? Recent market events have created an interesting ‘position vs. valuation’ perception. This has combined with a sudden shift from a unified positive view on synchronised global growth to one of doubt.
As a contrarian investor, I'm often looking for stocks that other investors have shunned
Of course, such an approach requires patience and investment discipline. To take a recent example, the company 'Flow Traders' benefitted strongly from the return of a more volatile risk environment in early 2018. They announced that they had generated "more than considerably" higher revenues in the first quarter of this year than the previous all-time high for the company. We believe that companies are ideally positioned to benefit in this market environment, as higher volatility should drive an increase both in trading activity and lead to wider bid-ask spreads, both of which can serve as performance tailwinds.
Avoiding the value traps
While we may not set out to be contrarian, our valuation approach can sometimes lead us away from popular sectors. We always look to avoid sectors in decline or with low barriers to entry and thus inclined to bankruptcy. This can help us avoid value traps, as our valuation approach steers us towards companies with a good degree of visibility on steady, recurring revenue growth and strong cashflow characteristics.
Contrarian calls are often opportunities that the market has not yet priced in, but where sentiment can shift quite quickly. For many investors, it’s sticking to a contrarian view which is harder than initially finding these opportunities. However, we maintain that for a long-term investor, this can be a credible source of potential outperformance.
*Facebook, Amazon, Apple, Netflix and Google
“Great things are done by a series of small things brought together,” according to Vincent van Gogh. We believe the same is often true of smaller companies.