SYZ’s Clements: A five-step guide for contrarian investing

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Many fund managers follow the path of contrarian investing to achieve outperformance. But despite hundreds of competing contrarian managers vying to stay ahead of their respective benchmarks, consistent long-term outperformance remains relatively rare. Five steps below outline how to succeed.

Widen your time horizon

How can one make a difference against hundreds competing to get ahead of the herd? One way is to have more information than the competition, but, in this age of instant information, it is either impossible or illegal. Another option is to do a better job at analysing the information. But this is also quite a challenge considering the sheer volume of research carried out by thousands of global analysts. Therefore, the only realistic way to beat the market is by adopting a longer time horizon in order to allow good ideas sufficient time to come to fruition.

Patience is a virtue

Buy low and sell high. This stock market adage sounds easy, but it hides a painful truth: buying low is easier said than done. Indeed, it requires great courage to resist peer pressure and avoid fashionable but expensive stocks. It can also entail buying companies that nobody likes or investing in times of panic.

Above all, investors should be patient. This means doing your homework and waiting for the market to fall so you can find a good entry point from a valuation perspective. And then waiting again, sometimes years, until the market changes its mind and other investors realise the merits of the stock.

 Avoid value traps

Unfortunately, cheap stocks can stay cheap for a long time. If you’re a fund manager, you can convince your investors to show some perseverance. This means holding your nerve to stay on the side-lines when the rest of the market rises and companies which you consider far too expensive continue to make daily gains. However, what your investors will never accept is to see your “hidden gems” stocks turn out to be “value traps” – companies that look cheap but are in fact suffering from a structural deterioration in their business model.

As a result, when investing for the longer term, it is absolutely essential to minimize downside risk and avoid sharp drawdowns. The way to achieve this is through forensic and demanding analytical research in order to understand the drivers of a company’s performance, assess the soundness of its balance sheet, and perform in-depth “worst-case scenario” simulations.

Identify sustainable competitive advantages

The two key rules to selecting the right stocks are quite straightforward. The first is to buy high-quality companies; the second is to buy them at an attractive valuation. This seems self-evident but, as is often the case, it’s easier said than done.

So what makes a company good? If you’re going to invest for the long term, you need a business that has a fundamentally sustainable competitive advantage. This can mean a strong brand, like LVMH; market dominance that gives pricing power, like Legrand; a low cost provider, such as Easyjet; or, having a technological advantage, like Sanofi. In order stick to the second golden rule – attractive valuation – a successful alpha manager needs to focus on free cash flow generation, as this is the real engine to wealth creation and less susceptible to accounting manipulation.

Understand why it’s cheap

Unfortunately, good companies generating a lot of free cash flow that are attractively valued do not grow on trees. It’s therefore important to understand why, at times, this may be the case. There are basically three possible reasons: negative investor sentiment against the country or the sector (as was the case for Spain after 2008); negative sentiment due to cyclical or “flight to safety” reasons when investors indiscriminately stampede out of equities; or company specific fears around its business model. Once the reason for the cheap valuation is determined, you can assess whether it’s justified or not.

Like all good ideas, contrarian investing relies on basic common sense and seems relatively simple. However, what appears effortless, in fact requires a huge amount of work, courage and discipline. More than in any other aspect of investing is patience is a virtue; positions are usually held for 3 to 5 years, many of them at the initial low price stage. A true alpha-generating contrarian manager requires nerves of steel and loyal investors, but significant outperformance and low volatility are the rewards to be reaped.

Mike Clements is portfolio manager of the OYSTER Continental European Selection Fund, at SYZ Asset Management.