YOU SAY “CON*TRAIR*IAN”, I SAY “CON*TRAAR*IAN”

STOCK UP ON SNOWSHOVELS WHEN THE SUN SHINES

Most folks know contrarians. Some folks are contrarians. When the consensus opinion is wrong (“it’s different this time” circa. Late-1999, “the Iraqis will dance in the streets, throw flowers and greet US troops as liberators”), it pays to be a contrarian. But when the consensus opinion is wrong, a contrarian is just one more ignorant SOB. So being a contrarian requires a methodology. And a steel spine and a casehardened head. Check out this quote from “On the Contrary: Why it Pays to be Different by James Montier in Investor Insights[i]:

Doing the opposite of everyone else is not something that comes naturally to us. Neuropsychologists Naomi Eisenberger and Matt Lieberman have found that social pain (the pain of not being included in the in-crowd) is experienced in exactly the same areas of the brain as real physical pain. So following a contrarian approach might well feel like having your arm broken on a regular basis. (Eisenberger and Lieberman (2005) Why it hurts to be left out: The neurocognitive overlap between physical and social pain, in Williams, Forgas and Von Hippel (2005) The Social Outcast: Ostracism, Social Exclusion, Rejection and Bullying, Cambridge University Press)

The Montier article quoted above recites several studies that demonstrate that a contrarian, value oriented approach can generate better returns that mainstream growth investing. And Montier cites a GMO[ii] study that the Author cited in a“Desert of the Real” Newsletter. This GMO study demonstrates that as stock market volatility increases (stock prices fluctuate), people are less comfortable owning stocks.

Conversely, when prices are relatively stable, people are more comfortable owning stock. This probably reflects human nature and investor psychology. Rapid swings in price cause concern, fear, sometimes panic in people. But when stock prices are stable, the boat doesn’t rock and most folks are contented. Grantham divides periods of volatility into deciles, with the lower periods of volatility being the “comfort zone” and the highest periods of volatility comprising the “uncomfortable zone”.

NO PAIN, LITTLE GAIN
RIDE THE ROLLERCOASTER TO RICHES

As you can imagine, those who held stocks when volatility (and psychic pain) was the highest had the highest returns. Stocks returned 16% in the periods of the highest volatility. But those hammock loungers who held stocks only in the periods of the lowest volatility managed a return of less than 2%.

So those who jumped in during times of volatility had far better results. There are a few common explanations for these contrarian results. One is that many investors are unsophisticated chumps, buying high, selling low. Constitutionally incapable of playing the market right. There is some element of that. But there is another element to this phenomenon that is grounded not in psychology but in simple economics. Supply and demand.

TRY FINDING A SNOWSHOVEL AT THE HARDWARE STORE AFTER THE BLIZZARD HITS

Lord Keynes describes the logic of a contrarian investment approach quite elegantly:

The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.[iii]

This statement reflects the central theme of capitalist markets.

“[E]conomic trends mean revert because there is a powerful and persistent normal return toward which capitalist competition strives, competing down handsome margins and P/Es and avoiding low returns until shortages develop.”


THE AUTHOR’S NOT A PATIENT MAN

The Author has used value approaches on occasion. After the tech stock crash of 2000, the Author bought US Steel as a value play and made a decent return, selling it in 2003. Later, in 2004 when steel stocks were rising based upon high international demand for steel, the Author bought US Steel as a momentum play. And that play worked as well.

The Author does see merit in a value approach. At certain times in certain markets. The means reversion mechanisms of markets never fail. But who knows when they will work?

But since the Author uses a relative strength, momentum based investment style, he leaves his value investment portfolio component to the experts, value fund managers. The Author’s value investment is the First Eagle Global Value Fund, SGENX. The fund is closed to new investors at this time, but the Author will inform his readers when it reopens.

Value investing also requires strong analytical capabilities to ferret out under priced investments and the patience to hold them until their value is again recognized by the market. And who knows how much time and patience it will take. Remember another thing that Lord Keynes said:

The markets may remain irrational longer than you can remain solvent [!]

WISHING YOU PATIENCE IN TIMES OF VOLATILITY IN THE DESERT OF THE REAL!

[i] http://www.investorinsights.com/. January 30, 2006.
[ii] http://www.gmo.com/ Jeremy Grantham runs the GMO investment firm. The author frequently cites Grantham in his posts and newsletters. The Author does not own any GMO investments, but members of his family do. Please also read the Disclaimer at the end of the post.
[iii] http://www.gmo.com/



IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.