As harrowing as the recent market sell-off has been, widespread pessimism surrounding the global economy has been creating opportunities for valuation-conscious investors. For much of the year, Morningstar's equity analysts had considered stocks in their coverage universe to be slightly overvalued. But as a result of the harsh sell-off in the last week, the average stock in our coverage universe is now trading at a more than a 10% discount to fair value, and our analysts think there are several high-quality names that now appear to be rather cheap.
Picking up mispriced stocks is a contrarian investor's objective, and such opportunities invariably surface when the market is looking particularly weak. Being willing to purchase out-of-favour stocks, then selling them after their share prices have recovered, can obviously lead to above-average gains. On the other hand, avoiding companies where there is excessive optimism about a stock or sector can help the contrarian avoid market bubbles like the late 1990s’ technology heyday and the Nifty Fifty era of the 1970s.
As lucrative as a contrarian strategy might seem, executing isn't exactly straightforward. Here are three pointers for going against the crowd without getting trampled.
Delegate to a Good Contrarian Manager
If you're attracted to a contrarian strategy but aren't comfortable betting on individual troubled companies, buying a fund whose manager employs a contrarian approach is the way to go. Such managers look for securities that are (sometimes deeply) out of favour, but they can take a diversified tack and might be backed by extensive research teams and resources that are not available to the individual investor.
Notable contrarian managers that we would highlight include Fidelity Special Situation’s Sanjeev Shah (Morningstar analysts rate the fund Superior), Schroder Recovery’s Nick Kirrage and Kevin Murphy (also rated Superior), and GAM manager Andrew Green, who manages both GAM UK Diversified and GAM Global Diversified.
We would also suggest that M&G Recovery lead manager Tom Dobell’s starting point can be classified as contrarian, though given his long term focus not all the holdings in the fund would necessarily fit that profile over time. M&G Recovery carries an Elite rating from Morningstar analysts. (Morningstar fund research is available to Premium subscribers, find out more here.)
Keep in mind that even though these managers boast impressive long-term track records, it is not uncommon for funds such as theirs to suffer short-term lags. If you want to invest in a fund that has large stakes in the unloved, make sure you have a long time horizon and the discipline to hang on through rough patches.
Mind the Downside When Investing in Individual Stocks
If you decide to invest in individual stocks rather than investing in a fund, remember that badly beaten-down securities are usually down for a reason, and there's a possibility other market participants know something you don't. Thus, investors buying individual stocks should not forsake the long-heralded benefits of diversification when employing a contrarian tack. Pound-cost averaging and diversifying across multiple sectors can help mitigate security-specific risk.
Contrarian stock investors should also take pains to discern whether a company's stock is a true value or a so-called value trap. Both value stocks and value traps might look undervalued based on standard metrics such as price/earnings ratios or price-to-book value per share measures. But value traps are marked by inferior fundamentals. Investors must determine whether a company is experiencing a temporary setback or whether their buy-in will be the start of a death spiral.
Ask yourself some key questions that will help you distinguish between a bargain stock and a value trap. Does the business have strong fundamentals; that is, does the company have a solid balance sheet with little or no debt and also generate plenty of free cash flow? Is its brand intact? Is its market position sustainable and growing?
Implement a Contrarian-Lite Approach
Sticking to a disciplined, regular rebalancing programme is yet another way to be a contrarian without taking on the risk of buying a stock that has fallen but can't get up. Rebalancing is an inherently contrarian practice because in the case of an equity market decline, this would mean buying more stocks to raise your stock allocation to your original target, or in the case of market increases, selling stocks to reduce the stock allocation back to the target.
Rebalancing is easy to grasp in theory, but difficult in practice; indeed, many investors actually do the opposite--buy stocks at market highs and sell stocks at market lows. As a result, even if the FTSE 100 index has made gains, such investors only manage to capture a slice of it. This performance gap would be mitigated by practicing disciplined portfolio management in the form of rebalancing. Investors can also rebalance among different investment styles; for example, a contrarian might have whittled away his small-cap exposure recently and moved money into large-cap stocks.
Read Christine Benz's Speculating in a Turbulent Market to see what she has to say about avoiding additional pitfalls that befall contrarian investors, particularly in a volatile market.
Listen to Morningstar UK Equity Manager of the Year 2010 winner Alastair Mundy explain what makes a true--and successful--contrarian manager here.
