What's it like to be a contrarian investor? See that meat grinder over there? Go stick your head in it.
It's a gruesome metaphor, but contrarian investing isn't for the meek: Buy what others detest and reject ideas that are practically sacrosanct.
Embrace controversy and divisiveness. Flout consensus. Be the unmentionable in the punch bowl, the jerk who shorts technology stocks in 1999, rents his house in 2005, or buys bank stocks in 2009. Have your sanity questioned repeatedly.
It's not for nothing that momentum tends to rule the markets, that benchmarks are the divining rods for portfolio managers, and that investors chase performance. We hate losses and seek affirmation, which we find in the herd. We're too impatient to wait for the rewards of long-term investing, and so trade on short-term stimuli. Contrarian investing, by contrast, is uncomfortable and solitary. It confounds the way we're wired as well as the incentives that society dangles to bring us into line. Who wants to crouch alone in the corner, after all?
But the fact is that investing is a test of patience and resolve. And what sets contrarianism apart is the head-on way it acknowledges this sobering reality. It's the ascetic approach to investing that says, in so many words, "no pain, no gain."
It also says, with a tinge of cynicism, that nothing succeeds quite like failure. The best contrarian investors-your Buffetts, Templetons, Klarmans and Greenblatts-exploit others by inverting emotions like fear and greed to their advantage. That is, investors who succumb to impulse tend to buy high and sell low. Contrarians are only too happy to take the other side of these trades.
Of course, the iron law of capitalism is that success invites competition, a process of attrition that can whittle away profits. In the investing world, successful strategies can suffer a similar fate, with excess returns getting arbitraged away as a trade grows increasingly crowded. What, then, is the "moat" that protects contrarian investors, explaining the durable success some have enjoyed?
Contrarian investing has endured for a few reasons:
• The "ick" factor: Contrarian investing is not sexy. In fact, given the frequent pangs of self-doubt and second-guessing that go along with it, one could argue it's nausea-inducing. Further, contrarians are prone to invest in the market's least palatable securities and sectors, provided they get cheap enough. To many investors, this seems like the path of greatest resistance, which they're unwilling to take. This tends to thin the herd.
• It's tough: Contrarians, by definition, take out-of-mainstream positions. While the crowd doesn't always get it right, markets are quite efficient and momentum can be powerful over shorter periods. Thus, it's not enough to be brave-one has to sport an information advantage that only dogged and differentiating research can confer. That requires a hefty amount of not-very-glamorous effort, which few are willing to devote.
Taken together with the underwhelming results of short-cut approaches like "Dogs of the Dow," these factors have reinforced the idea that successful contrarianism is best left to the pros, making it the preserve of very experienced investors.
Yet, a number of developments have put that notion to the test recently. For example, several celebrated contrarian investors, including Legg Mason's Bill Miller and Fairholme Capital's Bruce Berkowitz, have suffered painful comedowns as their flagship strategies have underperformed. In addition, a number of prominent value managers, contrarians among them, stumbled badly during the financial crisis when they mistook the glint of falling knives for the glimmer of value.
The market also has evolved in ways likely to weaken the hold that the professional investing class has on contrarianism. Correlations have risen, for instance, meaning that markets are arguably becoming less discerning in the way they value individual securities. In a related development, baskets of securities such as exchange-traded funds have become increasingly prevalent, while data on trends affecting broad classes of securities has become more widely available. This has hastened a shift from the micro to the macro, the individual security to classes of securities.
This has important implications for contrarians. For instance, it complicates the process of investing one-by-one in beleaguered stocks, bonds or other assets in hopes that they'll revert to a price that approximates intrinsic value. Why? The process of mean-reversion, an article of faith among contrarian investors, depends on the market's willingness to distinguish between securities and value them on their merits. The hopeful corollary to that is this: to the extent that securities move in herds and investors have access to vehicles like ETFs, it should be increasingly possible to implement rules-based contrarian strategies that target areas of the broader market that have been oversold.
How might an investor go about this task? For a number of years, my employer's parent company, Morningstar, has examined the power of mutual fund outflows as a contrarian signal. The study, called "Buy the Unloved," tracks the performance of fund categories that have suffered the heaviest redemptions of assets. What it has found is that "unloved" categories tend to outperform popular areas, the logical explanation being that heavy selling left them inexpensive, conferring better returns in the years that followed.
Here at Morningstar Investment Services, we recently attempted to make the "Buy the Unloved" concept investable. Using a rules-based methodology, we built a portfolio that invested varying amounts in ETFs representing the five most unloved categories of the past five calendar years. What does it look like right now? It tilts heavily to stocks and away from bonds; it overweights cyclical stocks, including banks and REITs, and treads lightly in defensive issues; it substitutes credit risk, via corporate bonds, for interest-rate risk. It does, in so many words, the opposite of what investors have generally been doing in recent years, expressing a highly contrarian point of view on the markets in the process.
While an approach like this one won't appeal to all, it removes some of the hurdles that often stand before mom-and-pop investors. Namely, you don't have to quit your day job, hire droves of analysts or spend outlandish sums on research or trading technology. You can invest with fairly surgical precision in narrow market segments that have been laid low by sentiment. And you don't have to fret about summoning the courage to implement the strategy-hold your nose, follow the rules and let the process take its course.
By principle and temperament, we can't all be contrarians. But the advent of low-cost tools like ETFs and the shift in markets from the individual security to broader classes should make it easier to invest with the discernment and nerve of what we believe to be the best contrarian minds.
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