Whether you're playing sports, managing a business or raising a teenager, anticipating what's next will usually hold you in good stead. The same can be said of managing your investments. If you're rebalancing your portfolio or initiating new positions—funding your ISA, for example—it’s wise to do so with a contrarian mindset. Last year's winners will rarely make for a good shopping list because their valuations are often inflated. Instead, when deploying new assets, you're usually better off looking to parts of the market that have underperformed and may be due to recover.
Of course, beaten-down pockets of the market may be cheap for good reason, and that should be of particular concern for contrarian types today. As investors have been in "bring on the risk" mode for five-plus years, you can bet that they'd be pouncing if easy opportunities were hiding in plain sight. Most of today's beaten-down market pockets are in the dumps because of some combination of falling energy prices, concerns about global economic malaise, and too-low inflation—intertwined issues that won't resolve themselves overnight.
Thus, investors aiming to capitalise on the markets' down-trodden pockets today should make sure they fully understand the fundamentals (including the bear case) of any prospective investment, have an appropriately long time horizon to capitalise on a potential recovery, and keep those more speculative positions to a small part of their portfolios. Alternatively, investors who would rather not buy individual stocks or sector-specific ETFs might consider delegating the contrarian decision-making to a good value-oriented stock-picker who can conduct due diligence on their behalf.
What follows is a review of some parts of the market that could be poised for recovery owing to poor performance, investor redemptions and cheap valuations—or some combination of all three. Within each area, I've highlighted some individual stocks, exchange-traded funds, and actively-managed offerings for your consideration.
Precious-Metals Equities
The Thesis: Asset-allocation guru Bill Bernstein piqued my interest in gold-mining equities this past autumn, when he enthused about them at the annual Bogleheads Conference. Not only does he consider these securities to be among the best diversifiers for portfolios consisting of stocks and bonds, but he also thinks the timing is right, as gold-mining stocks are in the dumps. (That stands in contrast to his stance in 2011, when Bernstein presciently said that the asset class was overvalued.)
Kristoffer Inton, who covers gold miners for Morningstar, agrees that the stocks look cheap right now; the typical gold miner in Morningstar's coverage universe is trading at a 20% discount to fair value. Inton points out, however, that most miners have historically made poor capital-allocation choices; the stocks will also be buffeted around by gold-price fluctuations. Thus, investors considering an investment in mining stocks should limit it to a small slice of their portfolios and have a long time horizon.
For the Stock-Picker: 
BHP Billiton (BLT) is one of few 5-star rated UK stocks under Morningstar coverage as of mid-January 2015. BHP, the world’s largest publicly-traded mining conglomerate produces a range of commodities from oil and gas to nickel, and is a major producer of iron ore, copper, thermal coal, metallurgical coal and manganese. Rio Tinto (RIO), however, is more of a precious metals miner, with operations including world-class hubs in aluminium, coal, copper, diamonds, gold, iron ore, industrial minerals and uranium. The stock currently looks fairly valued, earning it a 3-star rating.
For the Indexer: Two exchange-traded funds—iShares Gold producers UCITS ETF (IAUP) and ETFS DAXglobal Gold Mining GO (AUCO)—provide broad exposure to gold-mining stocks. The more popular of the two, as measured by assets under management, is the iShares fund which offers broad physical exposure to the largest publicly-traded companies involved in the exploration and production of gold globally. By contrast the ETFS fund offers swap-based exposure to a more concentrated global mining index.
For the Active-Management Aficionado: BlackRock Gold & General is run by seasoned portfolio manager Evy Hambro, who heads up BlackRock’s renowned natural resources team. This is amongst Morningstar’s highest-rated funds within the precious metals sector, boasting a Gold rating. The fund’s focus is on lower-cost, higher-quality producers with the aim of generating steady outperformance in a risk- and liquidity-aware manner.
Energy Stocks
The Thesis: With oil prices falling through the floor, energy stocks have become cheap in a hurry. In the near term, senior analyst Jason Stevens expects excess oil supply to weigh on oil prices—and, in turn, energy-stock prices. But he thinks oil prices will recover once supply/demand imbalances correct themselves. One major caveat, in addition to the difficulty in predicting energy prices: Many diversified portfolios may well include ample exposure to energy stocks already. For example, the FTSE 100 currently has 15% in the energy sector.
For the Stock-Picker: A broad swath of industries under the energy umbrella are currently trading at sizable discounts to Morningstar analysts' estimates of fair values. Among top picks in the sector, are BG Group (BG.), BP (BP.) and Tullow Oil (TLW). All three carry 5-star ratings and narrow moat ratings, though they also carry fair value uncertainty ratings of medium or high. That reflects the difficulty of determining what the companies should be worth, given the wild card of fluctuating energy prices.
For the Indexer: Both iShares STOXX Europe 600 Oil & Gas (EXH1) and Amundi ETF MSCI World Energy (CWE) offer diversified exposure to the energy sector at a very low cost. The iShares fund offers physical exposure to the European oil & gas sector, whereas the Amundi fund offers swap-based exposure to the global oil & gas sector. It's also worth noting that both are heavily concentrated in their top positions. For example, Royal Dutch Shell (RDSB) represents almost a third of the iShares fund.
For the Active-Management Aficionado: Within the energy sector, the Guinness Global Energy fund is rated Silver and managed by experienced energy investor Tim Guinness with support from a strong team. The management team has successfully and consistently implemented the contrarian investment approach, investing across the broader energy spectrum.
Inflation-Protected Securities
The Thesis: With global economic weakness a concern for a number of years, and the overall price-depressing effects courtesy of falling oil prices in more recent times, investors may be strongly tempted to disregard the need to insulate against higher prices. Indeed, UK inflation has declined sharply throughout 2014 and the expectations are for further disinflation – even the odd spate of negative rates – in 2015.
Of course, at present there's no apparent catalyst for higher prices or, in turn, demand for inflation hedges. The UK economy is performing comparatively well, although wage growth has been lacking. However, by altogether jettisoning inflation hedges, investors would be saying that they believe inflation will stay way down for the foreseeable future, and that may not be the case. Ideally, investors should consider setting up new positions or adding to existing holdings of inflation-linked products when inflation expectations are low, as it the case now, so as to minimise purchasing costs.
UK investors should not overlook the fact that UK inflation-linked gilts are indexed to the retail price index (RPI) rather than the consumer price index (CPI). RPI, which includes housing costs (i.e. mortgages), has proved more volatile than CPI, though both price series tend to follow the same trend. However, RPI generally tends to overshoot CPI – in December 2014, for example, annual RPI was 1.6% while CPI was just 0.5%. As such, UK inflation-linked gilts would normally give investors extra inflation protection from the get-go when pitched against the Bank of England’s CPI price stability target. This will be duly reflected in the performance of bonds and therefore also in the performance of funds that provide exposure to bond markets.
For the Bond-Picker: Individual investors can purchase UK inflation-linked gilts directly either from the UK’s Debt Management Office (DMO) – if you’re willing to put up with a rather tortuous process involving sending letters and paying by cheque – or via many brokers. Direct investment is not for everybody, though. For starters, one would need to have a comprehensive knowledge of the UK government bond market and also likely be able to devise a maturity-laddered investment strategy.
For the Indexer: L&G All Stocks Index Linked Gilt Index Trust, rated Bronze by Morningstar, and Vanguard UK Inflation-Linked Gilt Index are the cheapest index trackers providing exposure to the UK inflation-linked gilt market, both levying an annual fee of 0.15%. Meanwhile, for those investors preferring the trading flexibility of ETFs, the iShares GBP Index Linked Gilts ETF (INXG) is the most obvious option given its size and liquidity. It charges an annual fee of 0.25%. Irrespective of vehicle, the indices these funds track do encompass the entire maturity spectrum of the UK inflation-linked gilt market. As government issuance tends to be biased towards long maturities, the funds display high duration metrics.
For the Active-Management Aficionado: The nature of index-linked gilt funds means there are few actively-managed offerings but investors will find several funds in other categories such as the GBP Flexible bond category that have earned high ratings from our analysts. Henderson Fixed Interest Monthly Income fund is one such example, rated Silver, though it should be noted this fund, and others like it, is not directly tied to any measure of UK inflation.
Commodities
The Thesis: Commodities-tracking investments have fared particularly poorly over the past few years, owing to global economic weakness, sagging energy prices and slack demand for all manner of commodities, especially in emerging markets. Broad-basket commodities funds, which many investors use to ward against inflation, have dropped nearly 20% over the past three years.
Of course, it's close to impossible to predict the "right" price for commodities; that's one reason that many asset-allocation specialists believe they aren't a great addition to investors' tool kits. But for investors wishing to add a long-term strategic hedge against unexpected inflation to their portfolios, and perhaps do so at the right price, a small slice in a commodities-tracking investment could make sense. Morningstar Ibbotson's research recommends commodities allocation in the neighbourhood of 4% to 6% of the total portfolio.
For the Stock-Picker: Investors who wish to play falling commodities prices by owning the stocks of commodities suppliers should be aware that those firms' share prices will depend on company-specific factors as well as gains or losses in the value of the commodities they produce. I outlined some picks in the mining and energy sectors above, and investors might also consider the basic-materials sector more broadly.
For the Indexer: Investors seeking broad-basket exposure can consider the Lyxor Commodities CRB TR ETF (CRBU). It should be noted that for this fund, the exposure is particularly concentrated, with both energy and agricultural sectors each maintaining around 40% of index weight. Investors could also consider the more expensive db X-trackers DBLCI OY Balanced ETF (XBCU), which seeks to capitalise on the specific dynamics of the commodities futures markets by employing a proprietary optimum yield methodology.
For the Active-Management Aficionado: Investec Enhanced Natural Resources is rated Bronze and is managed by an outstanding team headed by Bradley George. It aims to deliver attractive returns, primarily through equities, with lower volatility than traditional long-only resources equity funds. During momentum-driven markets the fund has delivered strong returns well ahead of its benchmark and Morningstar Category average, and it has also shown its ability to outperform in severe market downturns.
International Stocks
The Thesis: Although investors continued to shovel millions into non-UK-equity funds last year, their loyalty wasn't rewarded. With the exception of a few strong pockets, notably India, China and Turkey, international stocks dramatically underperformed the UK in 2014. Here again, the stocks have slumped for nothing: Europe remains mired in a funk, and growth in emerging markets has slowed considerably, too.
Those situations won't be remedied overnight, but investors who are in rebalancing mode might consider steering some pounds to international stocks and funds. US equities look marginally expensive at today’s valuations, and UK stocks are fairly valued according to Morningstar's quantitative ratings for individual equities, but several eurozone markets and emerging markets are looking relatively inexpensive.
For the Stock-Picker: To help home in on high-quality, undervalued international stocks, I screened for wide-moat firms with low uncertainty ratings and at least 4 stars that happen to be domiciled overseas. The screen turned up a complement of energy companies, including NYSE-listed Spectra Energy (SE) and Exxon Mobil (XOM), but it also included firms in the consumer-defensive sectors, such as tobacco producer Philip Morris International (PM), which won't depend on an economic recovery to improve their profitability. My screen also threw up Australasian retailer Woolworths (WOW).
For the Indexer: Vanguard FTSE Developed World ex-UK Index fund is a strong core holding, featuring an expense ratio of 0.15% and one of the stronger track records within its Morningstar category. Morningstar analysts have awarded it a Silver rating. For an ETF alternative, iShares Core MSCI World ETF (IWDA) offers a competitive ongoing charge of 0.20% and includes UK exposure of 8%. In both cases, investors may want to consider pairing with some emerging markets exposure for a better-rounded portfolio. Two options are Vanguard FTSE Emerging Markets UCITS ETF (VFEM)and iShares Core MSCI Emerging Markets IMI (EIMI), both of which have an ongoing charge of 0.25% and use physical replication.
For the Active-Management Aficionado: Among the Gold-rated emerging markets equity funds, Aberdeen Emerging Markets Equity and First State Global Emerging Markets are two of the most popular, which is why they’re both soft-closed to new investment. However, if you are looking for a fund with a bit more exposure to value or contrarian plays, Lazard Emerging Markets is an interesting option, rated Silver. The fund has seen suffered some weakness in performance over 2014 but has a good longer term record. For a developed-market equity fund, GAM Global Diversified has a Silver rating and is a strong choice for investors seeking a value-based strategy.
Contributors to this special report: Holly Cook, managing editor of Morningstar.co.uk; Jose Garcia-Zarate, Kenneth Lamont and Caroline Gutman, passive-fund analysts; Simon Dorricott and Fatima Khizour, active-fund analysts.
