Contrarian Investing
It's Not Supposed to Be Easy
Hello fellow investors,
Welcome back to the JB Global Capital Newsletter. Today, we will be examining our preferred investment strategy, contrarian investing. As always, thank you for being a part of our growing community. We implore any new readers to consider signing up!
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The best opportunities are usually found among things most others won’t do.
Howard Marks
Contrarian investing is a strategy in which investors look to profit by betting against prevailing market trends. Some of the greatest investments of all time were strategically contrarian. The strategy is based on the following core beliefs:
Stocks have intrinsic value derived from business fundamentals.
Market prices swing dramatically around this intrinsic value, from overpriced to underpriced.
Most investors are trend followers and therefore bid up the price of popular stocks and sell/ignore unpopular stocks.
Most investors are short-term oriented and therefore bid up stocks that have the best short-term prospects and sell/ignore stocks with poor short-term prospects.
During market extremes, investors sell/buy at irrational prices due to fear or greed.
As such, the key to successful investing lies in doing the opposite: in diverging from the crowd. Those who recognize the errors that others make in the market can profit enormously through contrarianism. Howard Marks, in his memo It's Not Easy, puts it best when he says,
“Most people don’t understand the process through which something comes to have outstanding moneymaking potential. The very coalescing of popular opinion behind an investment tends to eliminate its profit potential. Superior investors know – and buy – when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit.”
Probability-Based Thinking
Probability-based thinking is an approach to predicting the outcome of a situation or the likelihood of a future event. Contrarians believe that the majority of investors do not think in probabilities and instead rely on past experiences, intuition, and emotion when making investment decisions. Emotion-based thinking is especially prevalent during extreme price fluctuations, as acute stress brings on the physiological fight or flight response. While fight or flight helped our ancestors survive life-threatening situations, it does not do us investors any favors in the stock market.
When a lion roars, we tend to run first and ask questions later. When markets crash, we tend to have a similar response.
Probability-Based Thinking and investing go hand in hand in that they are both counterintuitive in many cases. Brain puzzles such as The Birthday Paradox and The Monty Hall Problem indicate how thinking in probabilities does not come naturally. Gambling operations leverage our inability to think in probabilities in games such as roulette, which show the history of past outcomes, even though we know that the chances of any single outcome do not change, regardless of what came before it. It’s intuitive (and incorrect) to believe that if the color RED was produced five times in a row, then surely the chances of BLACK must be higher for the next turn. This same irrationality exists for many investors in the stock market, who track price movements much like roulette players.
Contrarians also believe that stock price history plays a major role in shaping most investors’ perceptions regarding the future prospects for a business. For example, if a company’s stock price has underperformed the general market for a considerable period, many investors will prioritize the negative aspects of the investment opportunity. Whereas, if the stock price has outperformed for a considerable period, investors will look favorably on the future prospects for the business. Always keep in mind, past performance is not indicative of future results.
While there are many famous contrarian investors, we find that Michael Burry (seen above) epitomizes a classic contrarian; an outsider who is attracted to investment opportunities that most others would avoid. In his letters to investors of his Scion Value Fund, he described his approach saying, “I tend to become interested in stocks that by their very names or circumstances inspire an unwillingness on the part of most investors to delve any further.” This approach is illustrated by his investment in Avanti Corporation.
Avanti Corporation was a software company that was at the time in the midst of a scandal and had entered into a plea agreement over stealing a competitors software code. The business was trading at a market cap of $250M, all while having roughly $100M of cash on the books and generating another $100M in free cash flow per year. Burry went to work on analyzing the business and reading through the court filings and determined that even with the worst-case scenario (executives jailed and maximum fines paid), the company was significantly undervalued relative to their balance sheet and current earnings power. Burry initially suffered a nearly 50% loss on paper amid the negative press, as the scandal was ongoing. He ultimately made a near 10-fold increase on his initial investment.
Burry is most famous for his bet against the U.S. housing market before the 2008 crash, as depicted in The Big Short. While his original thesis was nothing short of investment genius, what we find most interesting about the investment case is that Burry had to wait two full years for his investment to play out. During this time, the housing market continued to climb higher, causing his investors to second-guess his judgement and threaten to pull their funds. The case teaches us that contrarian investments require deep patience and commitment.
I fully expect and recommend that members of this investment vehicle judge my performance over a period of five years or greater, not five months or less. This will prove to be the most fruitful and enjoyable manner in which to participate in the fund. - Michael Burry, Scion Capital Letters
Historical Examples of Our Favorite Contrarian Investments:
Sir John Templeton (1939)- Buying Stocks during the start of WWII
Warren Buffet (1960)- American Express during the Salad Oil Scandal
Li Lu (1998)- Timberland during the Asian Financial Crises
Howard Marks (2008)- Corporate Debt during The Great Financial Crises.
Thanks for reading! We hope you enjoyed the discussion. If you found it valuable, be sure to leave a like and share with a friend.
Sincerely,
Jack Beiro, MBA
JB Global Capital
The information contained herein represents the author’s opinion and is for informational purposes only. Nothing in this newsletter should be construed as legal, tax, investment, or financial advice. No opinion expressed by the author should be construed as a specific inducement to make a particular investment or follow a particular strategy. The author may hold positions in securities mentioned in the newsletter and may buy or sell securities at any time. The author may express opinions based on information he considers reliable, but no guarantee or warranty is made with respect to such information’s completeness or accuracy, and the author is under no obligation to update or correct any information provided. Please consult your own financial or investment advisor before acting on any information provided herein.
Great writing. I enjoyed it tremendously!
Thanks for sharing these thoughts!