On The Contrary: Why It Pays To Be Different
John Mauldin's Outside the Box

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Introduction

Two weeks ago in Thoughts From the Frontline, I mentioned a piece by one of my favorite contrarians and behavioral finance analysts, James Montier of Dresdner Kleinwort Wasserstein. It was going to be the Outside the Box last week, but a previous letter by Montier was sent instead.

I normally try not to use the same author two weeks in a row, but this was an exceptional letter and I wanted to bring it to my readers. James pulls together research and observations from many sources in order to prove his point and show that being a contrarian is not always the easy path to follow. I have always said that the time to own equities will be during the next recession when everyone else has given up on them, but that will also be the hardest time to buy. James helps explain why it is so hard to be contrarian and that is why it is this week's Outside the Box.

- John Mauldin

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On The Contrary: Why It Pays To Be Different

By James Montier
January 12, 2006

Once a year we go through a totally pointless exercise in box ticking known as performance appraisal. As part of this internal navel gazing we receive 360º feedback on a variety of aspects of our jobs. One of the categories asks whether we "Challenge the consensus". Here is a selection of comments from responses that I have received in this section over the last two years:

"A tendency always to try to be non-consensus for the sake of it"

"This is so good that it almost becomes less than perfect. Some clients don't like to be criticised quite so much."

"Runs the risk of being too radical/contrarian"

"Simply too contrarian"


Given these comments perhaps I should explain why it is that I believe that following the consensus in markets will seldom, if ever, result in long term gains. To me an asset price reflects the sum of the market participants' view, as such the consensus' view is in the price. Now if the consensus is correct (which personally I can't say I've seen very often) then the investor gets the return embodied in the price (a 'fair' return if you like). Of course, if markets were efficient then this would be the case for all investors all of the time.

However, in a world where investors are driven by fear and greed, not mean and variance, other approaches can add value. For instance, if we see a marked tendency to over-react to news then one could either try to go with the flow (momentum) or bet on an eventual return to normality (contrarian strategies).

Moreover, in a world in which everyone is trying to outperform each other, doing what everyone else is doing is unlikely to generate outperformance. This is brought home in a new paper by Lehavy and Sloan. (Lehavy and Sloan (2005) Investor recognition and stock returns, available from www.ssrn.com) They show that the stocks institutional fund managers are busy buying are outperformed by the stocks the fund managers are busy selling.

In order to measure who is buying and selling, Lehavy and Sloan take the 13F filings from the SEC database. Under current legislation all institutional investors with more than $100mn of securities under their discretion are required to file quarterly reports on holdings. Lehavy and Sloan then constructed a measure of changes in ownership as 13F filers holding the stock at time t minus 13F filers holding the stock at time t -1, divided by the total number 13F filers at time t-1. Having constructed this measure, stocks were assigned to deciles depending upon the scale of the buying, so the top decile were stocks that lots of people were buying, whilst the bottom decile were stocks that people were selling. The time span covered by the study was 1982-2004.

The chart below shows the essence of Lehavy and Sloan's results. It shows the annual (size adjusted) returns for the top decile (those that everyone was buying) and the bottom decile (those that everyone was selling).

Both the pre- and post-portfolio formation performance are shown. In the pre formation years the stocks that ended up in the highest buying decile tended to have done exceptionally well. Indeed, those stocks that ended up in the highest buying decile outperformed those stocks in the lowest buying decile by around 3.8% p.a. in the preformation years. i.w they are buying stocks that have gone up.

However, in the three years after the portfolios were formed, those stocks that had seen the lowest level of interest from institutional investors outperformed those stocks with the highest level of attraction by over 4.5% p.a. Thus it appear to pay to do the opposite of what every one else is doing, or as Keynes put it "The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive."


However, such a strategy will be far from painless. Doing the opposite of everyone else is not something that comes naturally to us. Neuropsychologists Naomi Eisenberger and Matt Lieberman have found that social pain (the pain of not being included in the in-crowd) is experienced in exactly the same areas of the brain as real physical pain. So following a contrarian approach might well feel like having your arm broken on a regular basis. (Eisenberger and Lieberman (2005) Why it hurts to be left out: The neurocognitive overlap between physical and social pain, in Williams, Forgas and Von Hippel (2005) The Social Outcast: Ostracism, Social Exclusion, Rejection and Bullying, Cambridge University Press)

A further demonstration of the 'pain' of contrarian comes from an approach developed by GMO (the US fund management house). They created a simple model which relates the market PE (based on a Graham and Dodd measure) to the volatility of growth, corporate profits and inflation. We have replicated their approach below using the 10 year standard deviation of consumption growth, corporate profits and inflation as inputs to explain the Graham and Dodd PE. The basic idea is that when volatility is high people will find it uncomfortable to hold stocks, and when volatility is low people will find it easy to convince themselves that equities are a great asset class and hence end up paying more than they should.

The chart below shows the fit of our estimated equation against the actual Graham and Dodd PE. It is a pretty good fit with an R^2 of nearly 60%. So we can say that it would appear that equities prices are at least partially determined by the way in which people feel about the perceived safety of the asset class.


However, this model explains why people view equities the way they do. It is a behavioural model. It does not justify valuations. In fact, there is a negative correlation between the degree of comfort that people feel and the likely returns, if past history is any guide. The chart below simply breaks down the ten-year real returns depending on the zone of comfort that investors might have had based on the above model.


So the easier it may feel to own equities the lower the likely return! As the degree of discomfort increases so do the likely returns. In extremis, when it feels like owing equities would be complete madness, the likely returns are at their highest. A similar picture is true at the stock level. We have explored the role of sentiment in stock selection. We used work by Baker and Wurgler to show that when sentiment is high then one should concentrate on large, old, low risk, dividend paying stocks. Conversely when sentiment was low then it is likely to be profitable to invest in small, young, risky, non-dividend paying stocks. Unfortunately for investors, we are in the extremely comfortable zone for equity ownership suggesting that future long run returns will be very low.

It is this pain that deter many from following a contrarian approach. As Keynes noted "Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally" or if you prefer Voltaire's "It is dangerous to be right in matters on which the established authorities are wrong."

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So where are the big consensus trades at the moment? Several stand out. Firstly, everyone seems to want to rotate into growth this year. The logic seems to be that, after five years, surely value is due for some underperformance. I have shown elsewhere that in markets excluding the US it never pays to be a growth investor on average. In the US, there is a point when the relative pricing of value vs. growth gets tight enough to justify a switch into growth, but that isn't yet. So contrarians might be well advised to stick to playing value strategies.

Japanese equities are another consensus trade. I examined this in a weekly towards the end of last year. That note provoked an unusually high number of email responses, all of a very similar ilk. The vast majority went along the lines of "We like most of your stuff but...." followed by a list of reasons why my scepticism over Japan was misplaced. Still looks like a consensus trade to me, foreigners remain the sole buyer of Japanese equities, and surveys repeatedly show that the majority of fund managers are very keen on Japan.


Another trade that stands out as becoming overtly popular is to be long US, short Europe (or the equivalent style of trades such as lightening up on underweight stances against the US). This seems to be driven by the 'logic' that the US has underperformed for a couple of years, so it must be time for catch up.


However, this kind of argument ignores aspects such as valuations. The tables below show various valuation measures for both markets. Taking a simple equally weighted average across all these measures reveals that European markets are 27% overvalued, but that the US market is around 56% overvalued. Neither of these strike us as particularly attractive – a problem we have run into a lot last year, there just aren't a lot of absolute value opportunities out there. However, for those who love to play in relative value space, Europe may still look better value than the US. (One important caveat, this position is not independent of the general direction of the market. Not withstanding last year's 'decoupling' Europe generally remains a high beta play on US equities.)


Small caps are another overcrowded consensus trade. As my colleague, Andy Lapthorne, noted in his Quant Quickie (14 September 2005) small caps are trading at a premium to large caps, and run the risk of disappointing the high expectations that are currently embodied in their prices. Many are talking of rotating into large caps, but there is little evidence of this happening yet.

As regular readers might recall, I run a value orientated country screen to aid with global equity market selection. Based on this simple value screen Belgium, Norway, Netherlands, UK, France and Singapore all look attractive, whilst Denmark, Austria, the US, Switzerland, Canada and Japan all look relatively expensive.

Amongst the emerging markets Venezuela is the world's cheapest market trading on just over 7x 12 month trailing PE. Other cheap markets include Thailand, Indonesia, Peru, Korea and Brazil. On the expensive side we find Jordan, Egypt, Colombia, Czech Republic, Chile and Israel.

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Looking at this list of potential buys I have no doubt that many investors will recoil, arguing that such markets are cheap for a myriad of perfectly sensible reasons. For instance, Venezuela and Norway will be dismissed as simply a play on the oil price – they may be, but a cheap play nonetheless. Perhaps investors would do well to remember Sir John Templeton's words of wisdom "To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest rewards." Of course, that won't actually make it any easier to follow such strategies.

Conclusion

I hope you enjoyed this look at contrary opinions.

Your not always consensus analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

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Posted 01-30-2006 9:56 PM by John Mauldin