Understanding Contrarian Investing

Confusion abounds about what contrary thinking is. Any mother would consider it an insult were someone to suggest that her baby was contrary. What mother wants to have a contrary child? In the investment world, the word generally has more complimentary connotations, though there is still little clarity on what it precisely means.

Many think that contrary means always going against the majority that a contrarian investor is automatically acting in counterpoint to the current market trend. In a long bull market, this implies being like Cassandra, who made doleful predictions that were met with scorn, and while ultimately proved right, was never believed at the time. Similarly, on this view, contrarians bet against the common wisdom in the hope of making a killing.

Another angle contrasts the contrarian with the fundamental or value investor, who buys and sells on the basis of assets' prices relative to their intrinsic value (see Value Investing). Instead, a contrarian trading strategy is based on the assumption of negative serial correlation of prices: a predictable pattern such that if prices have gone up, they must come down, and vice versa. This view of contrarians focuses on the important role of fads: rather than acting independently, investors exhibit herd-like behavior, following waves of mass optimism and pessimism

To a third group, contrarian investing is the reverse, a steadfast adherence to value- or asset-based investing. David Dreman, for example, who has written two widely read books on contrarian investing, writes a regular column for Forbes and manages a successful investment firm, describes it as "buying stocks that are out of favor according to some well-defined, fundamental measures such as low price-to-earnings (p/e) ratio, low price-to-book, or high dividend yield."Dreman is attracted to stocks that have declined in price on the assumption that a price return to something like the mean will give him a profit. He uses traditional ratio analysis of yield, p/e and book to screen his list. This is more the strategy of a traditional value investor than a contrarian, though in some sense, Dreman is still being a contrarian to the nifty fifty growth stock era of his apprenticeship in investments

In reality, contrarian investing is none of these: though the tactics of a contrarian may resemble one or more of these naive descriptions, they miss the point and seriously so. Contrary thinking is most like intellectual independence with a healthy dash of agnosticism about consensus views. While it is true that if a consensus grows to be a herd or crowd, the contrarian will flee. But not necessarily to the exact opposite. Instead, identification of a herd charges the contrarian to be more rigorous in independent thinking. And the contrarian is more likely to be attracted to a point of view that has not yet been thought of the empty file drawer idea than one that has been considered and rejected.

Contrary ideas usually guide broad strategies rather than specific investments. For example, in the late 1990s and early 2000s, Russia might be seen as providing excellent contrary opportunities in the aftermath of its 1998 debt default and currency devaluation and the subsequent flight of capital.

Timing is not usually indicated by a contrary approach. And because true contrary ideas are not an automatic knee-jerk reaction away from the consensus, there can be a number of different, good, contrary reactions to the same challenge. All may be appropriately contrary.

Predicting market

The latest research in financial economics seems to confirm that markets are not strictly efficient and that there are pockets of predictability. This offers some hope to "disciplined" active managers if they can come up with innovative techniques to achieve superior long-term returns

But it is very important for any investor to watch closely for changing market drivers. For example, the market drivers until late 1998 were easy credit, moderating inflation, lower interest rates, rising earnings and the wide publicity of nearly an eighteen-year bull market in equities by some counts, a fifty-year bull market. The 1990s have seen a 16% compounded rate of growth for equities versus 6% historically, so it is not surprising that strong momentum keeps everyone in the game.

But we are beginning to face a different set of market drivers and it is hard to tell where they will drive us. The kind of financial concerns we face are rather novel in all of our lifetimes. There is illiquidity; wealth has been destroyed in many parts of the world; and inflation has turned to disinflation, to lower inflation and now to deflation. Deflation is destructive, especially for debt, which has led to a quality preference on debt where only the highest quality can pass muster and the ability to borrow is probably the only thing that counts in analyzing securities (see Value Investing).

What about the impact of news on portfolio management decisions? It is worth noting that precisely the same evidence may be used to support a good market tone or a bad market tone a bull market or a bear market. For example, the absence of rising prices could be good for continued growth and low unemployment, or it could be bad because deflationary forces are building up and, as the experience of Japan indicates, they are extremely destabilizing. Interest rates are attractive for borrowing and money is plentiful, which is very good for business; but it may well be bad because it means that a great deal of money is flowing in from overseas to the United States as the last fortress of capital.

Similarly, the public continues to buy IPOs (see Initial Public Offerings), almost every single one. Is that good because it means confidence or bad because it means that there is such a strong psychological undertone to the market that when it cracks, nothing will bring it back? What is more, the quality stocks have done much better for the last several years than the broad market averages. Good because it suggests leadership? Or bad, meaning that there really is a low level of confidence, and this is just speculation in well-known names?

Also, we have continued concerns about what will happen in the year 2000 with our computer systems. Good if nothing happens or bad because the year 2000 is only months away? Finally, earnings are good, but on the other hand, the majority of the surprises are on the downside: there appears to be a deterioration in terms of buildup of disappointments. So the same news can be seen as good or bad.

Bill Miller's Advices

It is hard to be the best performing manager for the past five years out of a field of more than five hundred. Not just that it is so difficult to be there and it is but also difficult to maintain one's mental balance. The temptation is to be too cocky and believe the publicity one receives. Or one could become too concerned with the inevitable stumble that lies ahead: old Bill has just lost it, some will say.
One way Bill Miller of Legg Mason's Value Trust keeps his head is to stress the intellectual side of investment. And he concentrates his investment attention so that extraneous contemporary PR does not distract him. His job is to outperform and every instinct he has is brought to bear on that objective. Over and over, he can repeat his lessons from profits and losses. His shareholders' glories and pains are his own. He takes the lessons, structures them into principles and keeps improving.

Miller is rather liberal in defining the details of his tactics when it suits him. He is not bothered by people who say that Czech bonds, for example, or go-go technology stocks trading at sky-high price-to-earnings ratios are not value investments: if they go up, they were and that is what counts. The definitional straitjackets of others are their problems, not his.

Miller is reaching out to complexity and the Santa Fe Institute, where he is a trustee and has a house, to teach him how to break today's investment bronco. Few others have the patience to deal with the ambiguities inherent in any emerging science. And it lets him contemplate the future of investment styles with a catholic perspective, a dogged determination to triumph and in the company of physicists ready to humble anyone wasting a good mind on one of the soft sciences, for money.