Contrarain Investment

I recently came across a book written in 1998 that a few smart hedge fund managers that I respect said had a great influence on them. I summarize its key points below, but don't let that stop you from reading the book yourself!

"Contrarian Investing" By Anthony Gallea. Written 1998.

In 1998, Anthony Gallea, a Portfolio Manager at Smith Barney, with help from William Patalon, a professional writer, wrote the classic “Contrarian Investing.” Jim Rogers wrote the forward to the book. Many successful investors have cited this book as a book that greatly influenced them. This volume, like Ben Graham’s “The Intelligent Investor” is at times dated, yet full of classic investing principles that stand the test of time. Every serious stock market investor must read this book.

General contrarian ideas:

§ Watch out for “this time it’s different from all other times” in the press.

§ Don’t “buy when blood is in the streets.” See the blood, wait a while, then buy.

§ “Study and think, think and study.”

§ “Buy on the cannons, sell on the trumpets”

§ Success as a contrarian demands a long-term view (2-3 years).

§ Contrarian: buying when others won’t. Once we’ve bought, we want other investors to come around to our point of view.

§ Contrarian path is not always an easy one to travel.

1. What is a contrarian?

A natural skeptic. If everyone believes something strongly enough to have already acted on it, there is profit to be made in taking the opposite position. This requires a real consensus, an extreme of opinion, not just a 10% stock drop. Contrarian investors succeed by not only disagreeing with the crowd, but knowing when to act on that disagreement. They are looking for extremes in opinion.

Contrarian indicator buy signals: insider buys, P/E below 12, p/fcf <10,>

It is hard to be a contrarian investor- often times you will be a detached thinker, a loner.

2. The contrarian advantage.

Independent analysis is the key ingredient to successful contrarian investing. Many investors are too scared, too lazy to think for themselves. They watch the superficial news instead of doing analysis. The media helps extend popular opinion, driving it to extremes in both directions. Contrarians do their own analysis and thinking, and take action on their unique beliefs.

3. The psychology of investing against the grain.

Society rewards conformity, just like a herd of animals requires conformity for their survival from predators. Contrarians think differently – they are independent, they ask questions others do not and approach problems in a fresh way- they reject the herd mentality. Analysts have to herd along because being wrong is OK, but being grossly wrong by being out of consensus is unacceptable. Then, when analysts are wrong, they engage in ego-defensive behavior and defend their incorrect stance. As investors struggle with new information, they tend to reject it in favor of beliefs they already hold. This is inherently irrational. Many investors believe that they are acting rationally, when instead they are acting emotionally, defending their own egos. It is not a good practice for contrarians to share their opinions with others, because it saddles them with the additional burden of “being shown wrong.”

4. Market Manias.

In nature there are no rewards or punishments, there are consequences.” As investments gather momentum, it gathers followers. Fraud is a great contrarian indicator that a market is getting overheated. (although I think it’s more of a lagging indicator, because the frauds are usually masked by a bull market – this time Madoff, GS, CDOs, mortgages, AIG, all came out after the market had crashed already) Head for cover when someone says, “it’s different this time” The market will always run out of “greater fools”. Manias are often fueled by easy credit/leverage. In 1929, it was 10-1 leverage on buying stocks. In 2008, it was 99-1 leverage in buying real estate.

Signs of manias:

(These are classic signs. Although the authors wrote this book 10 years before the 2008 meltdown, the latest real estate/mortgage/banking meltdown followed exactly the same script.)

1. Manias come during periods of prosperity.

2. Most manias are fueled by easy money and easy credit.

3. All manias are characterized by ever-widening acceptance.

4. Manias are always supported by authoritative opinion that reassures speculators

5. Participants ignore the voices of doom, which are really the voices of reason, and later blame them for bringing the “good times” to an end

6. Mania’s tops are impossible to forecast

7. It is impossible to invest successfully in a speculative mania – it’s all driven by momentum (normal fundamental rules no longer seem to apply)

8. Manias all end with a crash so destructive that the pain is felt for years, even decades that follow.

9. as a mania progresses, demands for the investment burgeons, but so does the supply, and the newer offerings are always of increasingly questionable quality

10. All manias end abruptly and with little warning.

5. Technical analysis is a key contrarian strategy.

One buy signal is price down 50% from peak stock price. Very powerful, statistically significant indicator. Winston Churchill: “Nothing in life is so exhilarating as to be shot at without result.” Management shake-up is often a good reason to buy a stock. (IBM example)

6. Riding the Price trend.

"Only a fool holds out for top dollar” – Joseph Kennedy. A trend is the visible expression of current and past opinion. Very hard to predict when a trend will reverse. “The trend is your friend” is true- the profits only come while we’re riding a trend. Once you find a trend, ride it as long as you can. There must be a clear reason to force you out. Most of your money is made by sticking with a winning position, and not through frenetic trading. At major tops or bottoms, volatility tends to increase (True in 2008 bottom!) No one can accurately predict the length of a trend. Sometimes a stock is listless/trendless for months before a trend can develop.

7. Insider buying and selling gives insight.

A stock that is off 50% from high, and has strong insider or knowledgeable outsider buying is one of the best contrarian plays. (Insider selling is not a clear-cut signal, buying generally is). “Knowledgeable Outsider”: investors like Buffett, Kerkorian.

8. Fundamental stock analysis.

The authors favor the traditional low-priced screens for stocks, similar to the Ben Graham value investing principles. (I think true contrarians are even more flexible in their thinking – some of the lowest P/E stocks in the recent crash went bankrupt, especially banks) P/E below 12, P/BV<1.0,>

9. Low P/E ratio.

Book advocates buying low P/E stocks. I agree, but this is only one indicator, and not enough. In addition, earnings can be distorted by GAAP accounting and P/E can be distorted by large amounts of cash per share. EV/EBITDA or CF is maybe better.

10. Low P/Book.

Price below book can be a cheap entry point for a stock. Be careful that the book value is accurate, however. (Banks recently had inflated book values)

11. Cash flow, price/sales.

FCF = Pre-tax income minus Maint. CAPEX.

12. Sell signals.

(This chapter is mis-named. Instead of telling when to sell, the authors actually give some risk management guidelines.)

Things to watch out for:

1. Get Rich Quick – looking for the proverbial 10-bagger – you may be taking too much risk.

2. Confusing brains with a bull market.

3. Market tips from others should be ignored!

4. Hooked on the idea

5. Lack of knowledge- you must do your own research!

Risk management rules:

1. Less than 5% of portfolio per stock (I’d say up to 10% is fine)

2. limit exposure to a theme or industry to 20% (again, I’d go higher here since I concentrate my investments in the 3-5 industries that I know best, and accept the higher volatility that goes along with this approach.)

3. Use stop loss of 25% (or tighter)

Don’t “average down!” resist the urge to buy more – if the stock drops 25%, sell it and move on. Owning a loser consumes a lot of energy. But owning a loser twice is far worse. If you buy back, do it only higher than the price you paid the first time. This is counter-intuitive, but it confirms that a rising price trend has begun.

4. Seek noncorrelated investments

5. Don’t overlook the diversification benefits of international stocks

6. Always compare an investment’s risk and return to cash.

13. When to sell stocks.

Use stop-losses to staunch the bleeding. Accept that being wrong sometimes is just part of the business. Contrarians do not try to predict prices. No one knows where a stock’s price is going to go. Once a price trend is under way, no investor knows how long it will last, or how far it will run. Don’t waste time second-guessing yourself for poor or untimely selling decisions.

14. Planning to win: Creating your Contrarian Strategy.

Successful investors share two characteristics: 1. They have a plan, 2. they follow that plan with unwavering discipline. Successful investors build their styles over a period of years. They persevere. Eventually, their discipline, and their willingness to stay with what they know, pays off. Be patient. Be consistent. Ignore popular opinion.

15. Summary: The Rules of the Contrarian System.

The Buy Rules. Initial trigger: “down by half rule” Confirming indicators: Major buys by insiders or knowledgeable outsiders. Low P/E, P/CF, P/BV, P/S. Minor rules: stock must be at least $5 per share. Better off buying fewer shares of a high-price stock than many shares of a lower-priced one. Look for market caps over $150M. Consider a change in top management as a positive in a company with problems. Look for one-time events that hammer the stock.

The Selling Rules: put in place 25% stop-loss. Sell after 50% gain or 3 years (I disagree- I think you have to let your winners run) Exception to 50% gain rule – after 100% gain, set a stop that locks in a 70% profit.

Risk diversification rules: 5% purchase rule. 20% industry rule. High-tech stocks not suitable for contrarian investing (dated- this book was written in 1998 during the heat of the tech/internet stock mania)