From the September 2007 issue of Wealth Manager Web • Subscribe!

September 1, 2007

Contrarian Course

"Mary, Mary, quite contrary, how does your garden grow?" Who doesn't know that the nursery rhyme contrarian had her silver bells and cockleshells and pretty maids all in a row.

But what constitutes a contrarian in the investment universe? Contrarian mavericks may seek out low P/E ratios, out-of-favor companies and sectors, and even fallen angels. One type is a non-conformist--always acting in counterpoint to the current market trend. Another variety focuses on the disparity between fundamentals and expectations, observing that investors exhibit herd-like behavior in waves of optimism or pessimism. A third school--the one most commonly associated with the term--favors a form of value investing.

But what is a contrarian anyway?

When David Dreman wrote Contrarian Investment Strategy--The Psychology of Stock Market Success in 1979, he began by trying to define the word. "After the bubbles of the 1970s, we were looking for a style that could check enthusiasm and stop people from paying too much to get good returns," recalls Dreman, who founded and runs Dreman Value Management in Jersey City, N.J.

As Dreman points out, however, value investing can be disciplined or undisciplined. While some are strict, other value investors may change their own definition. Is value absolute or relative? Cal Brown, a wealth manager at the Monitor Group in McLean, Va., notes that famed value investor Bill Miller "got criticized a few years ago for considering Amazon a value stock." Brown, who practices passive rather than value investing, sees himself as a contrarian, in the sense that 90 percent of managers are active.

Investor Beliefs

Most individual investors think that the more volatile the stock, the lower the future returns will be. They expect that large caps will outperform small caps, that growth trounces value, and they are equivocal about the role of momentum. In general, they believe that the trend is their friend. "Interestingly, professional investors consider it goes the other way," says behavioral finance expert Hersch Shefrin. "In their view, high momentum means it is time for a correction."

In their research, Shefrin and Santa Clara University colleague Meir Statman have also discovered that people believe good stocks are the stocks of good companies. This finding carries profound implications. It means that investors regard as attractive stocks a large company, a company whose past sales have been robust and whose market valuation is high.

Yet it turns out that low P/E stocks stand to benefit the most overall from earnings surprises. Disappointing results hurt less, while positive earnings help the most. For high P/E stocks, on the other hand, positive surprises are almost built in and expected.

Investors must tolerate additional systematic risk in order to be rewarded with higher than average returns. That may mean holding stocks that exhibit more volatility than the market, or smaller caps, or value rather than growth (as measured by book to market). And those are the characteristics most individual investors shun!

The conviction that good companies represent good stocks is derived from a psychological shortcut social psychologists call the "representativeness heuristic." Researchers have found that most humans judge the likelihood of an event by making comparisons to similar events and assuming that the outcomes will be the same. Gamblers, for example, cling to an erroneous belief that luck flows in good and bad runs.

Using that heuristic, many investors will buy a stock after say, three year's good performance. In doing so, they are relying on the "case rate," Dreman explains, which could be a one-time or short-term event. Actually, they should be basing their decisions on the longer term "base rate"-- typically 10 percent per year for the market. As an illustration of the behavior, Dreman adds that people who hear of an isolated shark attack may be reluctant to go in the water, although the base-rate for shark attacks is one in five million swimmers.

Compounding the error is overconfidence--another psychological quirk. Although we often believe we can forecast accurately, we become stymied by too many dynamic, interchanging factors. In other words, we are better at linear than interactive reasoning, such as the skills required for a chess game. According to consensus estimates Dreman has run since 1973, analysts who believe they can offer whisper estimates with 2 percent to 3 percent err by over 40 percent.

Bridging Two Schools

Contrarian strategies tend to be associated with behavioral finance--the study of investor psychology and irrational markets. Although value investing had a life of its own before behavioral finance came along, it has now acquired a psychological underpinning.

On the other side, behavioral theorists generally pit themselves against the efficient market hypothesis (EMH) gang, who assert that most market prices adjust quickly and rationally to reflect all relevant information. Yet even within that fairly stark dichotomy, there is actually a surprising case to be made for unifying both views as contributors to the contrarian philosophy.

Dreman needed to know whether it was possible to generate alpha, despite the warnings of the efficiency theorists who insisted there were no bargains to be had. In the 1970s, he started with simple metrics, like low P/E ratios, high yields, or low price to book, and discovered that those stocks did significantly outperform the market. "The EMH guys hated us for a long time!" he chuckles. "They had a theory that no one could beat the market, but the irony was they couldn't break our work."

Those "EMH guys"--spearheaded by Eugene Fama and Ken French--somewhat expanded their efficiency model during the 1990s, They allowed that systematic risk determines expected returns, and investors must tolerate added risk in order to be rewarded with higher returns. Their multifactor model now includes size- and book- to-market as additional elements that help to describe differences in stock returns. (Mark Carhart later added past momentum as a fourth factor.) According to Shefrin, "Fama would still characterize himself as anti-behavioralist, although French is more flexible."

In any case, contrarians might find that in fact, both schools can explain some of their success. The difference is one of academic semantics, in that the behavioral finance camp would advise investors to exploit mis-pricing while the EMH brigade would suggest holding riskier portfolios. "If you try to get exposure to the four factors in a way that lets you have a riskier portfolio, chances are it will be similar to the behavioral description," Shefrin explains. "It won't be identical, but it will be a close cousin."

Another approach for reconciling the behavioral and EMH views is through complex adaptive systems. The stock market is usually efficient, as long as certain conditions are not violated. The most likely violation is a breakdown in investor diversity, says Michael Mauboussin, chief investment strategist at Legg Mason Capital Management in Baltimore. "We're willing to join in with a group to varying degrees; more formally, we all have different adoption thresholds." That is where the behavioral aspect kicks in.

Sentiment can lead to disconnects between fundamentals and expectations. Mauboussin adds, "Contrarians will be looking for indicators of diversity breakdown, combined with an analytical approach to understanding expectations." So, for example, when Cisco stock hit $100 a share in 2000, that run-up represented a diversity breakdown. That was a time to layer in the analytical questions about the fundamentals of the situation versus the expectations reflected in the price.

Fads become self-perpetuating and virtuous cycles as trailing returns attract even more inflows and boost valuations. Eventually, momentum shifts, people start to sell, and the trend reverses. Investment fashions begin with a seed of economic reality. For example, in 2000, small caps became popular as large caps and technology stocks sank. Interest rates declined, which disproportionately benefited smaller entities in accessing capital; the dollar strengthened, which hurt large caps and exporters. "Over the past couple of years, those fundamentals have reversed," says James Berman, president of New York-based JB Global. "New seeds have been planted for a large cap rally."

Pressures and Challenges

Mavericks and iconoclasts never have an easy time--in life or in investing. Advisors and their clients confront some daunting hurdles when they commit to a contrarian approach.

Investors must begin by struggling with their own psyches. Neurotically, they succumb to fear and sell at market bottoms; they indulge in optimism and buy recklessly, as did the doomed dotcom purchasers.

Retail purchasers face limits in their capabilities in terms of time, resources and ability. Certain successful contrarians, like Kirk Kerkorian, Carl Icahn and Michael Price, have specialized in taking large stakes in bankrupt companies with turnaround prospects. "Distressed companies are very risky, and an amateur simply cannot do that," Brown cautions.

Financial planners have a duty to nurture the psychological needs of their clients as well as their financial interests. They must absorb some of the pain and responsibility during times of trouble. Investors, who hate to feel stupid, need their advisors to assure them that they are still the brilliant people today that they were before their investments declined.

At the same time, advisors must deal with client pressure and peer pressure, not to mention their own psychological demons. They, too, often lose sight of the bigger picture and give up on contrarian strategies too early if they are taking too long to work. For example, many so-called value managers put 20 percent of their assets into high tech stocks at the top of the bubble.

At the Leuthold Group, investment strategist Steve Leuthold takes considerable comfort in his quantitative framework. His funds track 180 factors, in an effort to isolate as much personal bias and opinion as possible. They include elements like put and call premiums, public attitudes, hedge fund bullishness, momentum, supply and demand and intrinsic value. In 1974 during the bear market, Leuthold "salivated" at the opportunities he perceived, but it was the strength of his numbers that gave him the courage to act. "The crowd can be very right for a while, but typically, at extremes it is wrong," he insists. (Leuthold has always been a rebel by nature--still typing on a manual typewriter from his collection of 14-- though he has trouble getting the ribbons.)

Yet for many advisors, the cost of maverick risk is overwhelming. "If you appear too different from everyone else, your clients may get nervous and refuse to stick it out," explains Ross Levin, a wealth manager at Accredited Advisors in Edina, Minn. The key, he says, is to make sure that clients understand what you are trying to accomplish and to prevent them from bailing at just the wrong time.

That may also mean establishing an appropriate environment for an investing team. This is how Mauboussin, who works with Bill Miller at Legg Mason, describes Miller: "He doesn't suffer much loss aversion, which is to some degree innate. But he has also created an atmosphere that allows for first-class decision-making. People here think in a steadfast way about filling in values and taking out peaks."

Lastly, institutional constraints weigh on investor choices. "Investing is a profession with a slow, patient, thoughtful cadence," says Mauboussin. "However, the pendulum has swung from that professional outlook toward a business about gathering assets and generating fees."

Whereas the majority of investment firms used to be privately held, many are now public or divisions of financial conglomerates with more motivation to drive earnings than to deliver results. A marketing oriented organization may be inclined to issue funds in "hot" areas, be they REITs, commodities or 130/30s. "It may not be because the firm believes in its competitive advantage, but because it senses an opportune time to gather assets," Mauboussin adds.

Patience and Discipline

Most financial planners encourage their clients to stay the course and remind them that while the short term may be a roller coaster, they are still likely to end up on higher ground than where they began. Naturally, that tenacity proves easier said than done. Warren Buffett took flak in 1999 for shying away from dotcoms when they were all the rage. "People thought the old guy had lost his luster," Shefrin recalls. Although the "Omaha Sage" had the wealth, track record and fortitude to stick by his convictions, lesser investors lack the strength and resources.

It is key to remember that all investing is probabilistic. Every decision involves some form of signal, various underlying characteristics--and then the noise factor. What happens when the time period for observation is extended? Flip a coin 10,000 times, and heads and tails will come out equally, 50/50. The same principle applies when the market takes short-term noise and extrapolates it as if the noise were a real signal. That signal must reveal itself more gradually, against a background of economic and growth characteristics. "We need to figure out what the signal is," says Mauboussin, whose teams at Legg Mason engage in thorough discussions about the concept of time arbitrage.

An overly short-term focus also leads to myopic loss aversion. In other words, how frequently are investors checking their portfolios? Studies in loss aversion suggest that investors feel twice as much pain at experiencing losses as they feel satisfaction about their gains. So the more often they evaluate their portfolios, the more likely they are to suffer from loss aversion. It is up to their advisors to prompt them to think about time horizons more appropriately, especially where contrarian strategies are at work.

Levin, who describes himself as a "mean revertor," tells his clients that over longer periods of time, most categories, sectors and asset classes perform similarly; in the short term they experience huge disruptions. Persistent contrarians still need to rebalance rigorously to achieve efficient asset allocation. It is tempting to become emotionally caught up when the strategies are working, and fail to pull the trigger.

So Levin is constantly moving money from his winners into fresh categories, with the expectation that "things get temporarily out of whack." Indeed, as they buy low and sell high, contrarians like Levin and Leuthold readily admit they often buy early: Levin still holds a 4 percent position in Japan, despite the 20-year bear market there. But he warns that currencies are less inclined to mean revert, and that the yen has been falling for two decades.

Another risk that dogs contrarians is the "value trap." Investors may imagine they are buying at a discount when in reality, a company is going to pieces. "If you pay more than the intrinsic values justifies, you won't benefit," Berman cautions.

Despite the pitfalls, contrarians exude quiet confidence. Simply buying the lowest P/E stocks works well six out of 10 years, according to Dreman. Assuming you are running a large portfolio, with 100 or more names, you should be protected in the event one or two go bankrupt. Turnover frequency also plays a role, as do weightings.

Some years will inevitably be negative. Dreman and other value managers still shudder at the memories of the 1999 bubble, when some of the top value managers resigned or changed their portfolios entirely. Yet the story has a happy end. "Those were horrific years for us as contrarians," he recalls. "We expected it would take a long time to make up our losses. The good news is that, in fact we were back up 424 percent in 2000, with the S&P down 10 percent."

Vanessa Drucker, who used to practice law on Wall Street, wrote about second careers in February 2006.

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