Contrarian investors deliberately go against prevailing market trends. They buy when others are selling, and sell when others are buying. Why? This investment strategy is based on the belief that herd behaviour in the markets can result in mispriced shares – and mispriced shares present excellent opportunities for long-term investors.
This has worked out well for famous contrarian investors such as Warren Buffet, but do you have what it takes to follow this approach?
At the moment, there is an overwhelming desire to cut and run from the equity market and find safety in cash. Negative returns are painful and cloud our judgment. Yet, if one looks back at history, we find that the best gains were often accompanied with the greatest level of discomfort. Investing when something feels and sounds comfortable is seldom a recipe for exceptional long-term returns.
There are a few ways in which you can improve your decision-making process when negative sentiment and historic numbers threaten to dominate your thought process:
Ability to tune out the narrative
When the narrative is negative, opportunities may be overlooked. This is particularly relevant when considering the South African investment landscape right now. Sentiment is about as low as it’s ever been, and investing in South African stocks may seem counterintuitive. But as Warren Buffet advises, “be greedy when others are fearful”. Fear abounds, and because of this there are some excellent opportunities to buy premium stocks at discounted prices.
Tolerance for temporary drawdowns
It is critical to understand that short-term underperformance is part and parcel of contrarian investing. This is never a pleasant experience, but to achieve superior returns over the long run, you need to be able to bet away from the crowd, and to stomach the temporary drawdowns that may result.
As contrarians seek to identify mispriced shares, they will often buy what they believe to be good companies that are out of favour, and therefore available at a discounted price. Because it’s impossible to predict when the market will start to recognise mispriced quality, these investors may see their investment go south for some time before the tide turns. But for long-term investors who can ride out the storm, the return profile from these low valuation levels can be very rewarding.
Comfortable being different
The only way in which fund managers can deliver superior performance versus a benchmark or their peers is to assemble a portfolio that is different. The size of the opportunity to outperform will be determined by the degree to which the funds are different.
Some investors are happy to be invested passively, to sit in the relative comfort of the herd and/or to hug the benchmark, so that they have a high probability of achieving average performance with little risk of falling far short of it. On the other hand, if your definition of success is superior performance, you’ll have to be comfortable with a portfolio that looks different and behaves differently to the average.
While most people appreciate that superior performance requires contrarian decision-making, many investors find it difficult to stomach short term underperformance, especially when others may be enjoying the opposite.
Willingness to accept mistakes
Investors must also accept the risk of making mistakes. No cricketer scores a century every time they bat and even arguably the greatest batsman of all time can get a duck. Skilled managers will make fewer mistakes than their peers and will aim to expose their investors to asymmetrical risk – where the probability of a gain is higher than the probability of a loss. Even so, they will make mistakes and these mistakes will lead to losses. The investor who seeks superior performance will accept the inevitability of this fact, knowing that in the long run, they may reap the rewards.