A leap of faith can pay off ::

David Potts
Date: 30/11/2005
Words: 688
Source: AFR
Publication: The Financial Review
Section: Portfolio
Page: 29

Contrarian investment is easy - buy the ugliest, grittiest most unloved stock and wait, writes David Potts.

Forget the goose, it's the ugly duckling that's more likely to lay the golden egg. Buying an asset cheaply because it's fallen out of favour will pay off handsomely over time, but you need to hold your nerve.

The most recent example of contrarian investing hitting the jackpot is Aristocrat Leisure. It plunged to just over 80 ? in 2003 after a disastrous foray into South America and a subsequent management upheaval.

Buying then would have been a model of contrarian investing: cheap, out of favour, moving in the opposite direction to the rest of the market and surrounded by bad news. And, not least, requiring a huge test of faith by any investor.

Today, the shares are worth six times that.

But there's one thing atypical about Aristocrat. The recovery took less than a year from its bottom, a blink of the eye to a contrarian investor.

"The problem is timing," says Michael Clancy, chief investment officer at MLC. "You can get the direction right but be wrong by a number of years. Investors have gone broke."

Nobody sees contrarian investing as a good short-term or trading strategy.

"You've got to be very patient. How long do you wait by taking a value approach? Ten, 15 or more years," he says.

You would also have missed one of the hottest sharemarket rallies unless, that is, you had invested in 2001 after the tech wreck. In which case, under contrarian principles, you should have sold by now.

Worse, getting the direction wrong is like catching a falling knife. Some stocks are out of favour for good reason. Identifying them isn't difficult, but buying at rock bottom can be.

"The contrarian approach is appealing and cheap, but the biggest mistake we find contrarian or value style investors make is they buy too early," says Steven Gamerov, head of investment solutions at Advance Asset Management.

They enter a bizarre zone where contrarian meets chartist. One does the opposite to the market, the other says the trend is your friend. "They look for tools that ensure the price doesn't get cheaper, such as momentum factors and signals that the stock is turning the corner," he says.

In fact, the most reliable momentum indicator is very short term. "If a stock has done well in the past three months, it will do well in the next three," Gamerov says.

"The other mistake is the flipside. Typically they sell too early," he adds.

"Because buying cheap is the motivation, if the stock rallies, they get uncomfortable holding it and tend to sell out," he says.

But professional contrarians face more frustration than fear with a sharemarket at record levels having few bargains.

A leading contrarian investment company is MMC Contrarian.

"We go straight to the year low column in The Australian Financial Review's share list every day, though we usually know the company anyway," chief executive Kevin Eley says.

He's still looking, since it's holding 70 per cent cash, qualifying as a contrarian investment itself by trading at a discount to its assets of almost 20 per cent.

"The market always overreacts to news. It's usually right, but you have to assess opportunities when it's not right," Eley says.

MMC Contrarian bought Burns Philp shares when they were in the "high 40s" - cents, that is - and corporate raider Graeme Hart was seen as "not knowing what he was doing. The stock was over-geared".

But borrowing was not a problem in a stable cash flow business and "the market eventually got it right".

The shares trade at around $1.10, but the fund has since sold them, following Hart into Carter Holt.

Eley concedes that contrarians can buy too early, extending the wait or worse, catching a falling knife as the price keeps dropping.

"If you have the courage of your convictions, you keep buying. As it gets cheaper, the more you want to buy," he says.

He names PMP as an example of where he is buying more shares as the price drops.

MMC Contrarian is looking closely at several out-of-favour sectors: car component manufacturers, retailing, media and telecommunications.

Stocks include News Corporation - "totally under-valued because it was flicked out of the Australian Stock Exchange index and because of the poison pill, but the stock is not understood in Australia" - Millers Retail and Fosters.

Other contrarian fund managers have been buying Boral, Centennial Coal, Gunns, Great Southern Plantations, PaperlinX, Ridley Corporation and Ten Holdings. Arguably, airline stocks also fit the bill.

Perhaps understandably none are buying Telstra, suggesting a contrary contrarian strategy for small investors.

A contrarian approach favoured by Roger Montgomery of Clime Asset Management is choosing companies with low price to cash flow ratios. Excluding cyclical stocks and unit trusts, this made an annual return of 25 per cent between 1995 and 2001, compared with the market's 17 per cent.

A variation is the Dogs of the Dow (see box), adopted in Australia by AspectHuntley, which one wag dubbed Dingoes Down Under. Both seem to beat their respective indexes in most years, but the method is becoming a victim of its own success as more try it.

"Value-type strategies have been doing very well since the collapse of the dotcom boom so I don't expect the approach to do as well in the next five years as it has in the past," Montgomery says, suggesting investors "won't be terribly disappointed if they allocate a small amount to the strategy and look back in 2020".

One of the consequences of a contrarian approach is a concentration in a few stocks, and small- to mid-sized ones at that.

An avowed contrarian, financial adviser Travis Morien of Compass Financial solves the problem with a default asset allocation of one-third shares, one-third international shares and one-third listed property.

"Nobody has ever said why it shouldn't be a third each," he said. Within the share allocations, he has half in value funds such as DFA's Australian Value and Global Value trusts, and tilts the rest toward small stocks and emerging markets.

"It's hard to find great value anywhere at the moment. But I'm not pulling out. I'm back to one-third each with a slight international overweight." He's also slightly underweight listed property.

Japanese and European shares may still be suitable for contrarian investing, but you'll need to be fast because they're finding favour again. Their property markets probably fit better.

Asian markets are already on a roll, so it's too late for them.

But there's always gold, which is only now coming out of the doldrums. Bullion tends to move independently of everything else, and some advisers suggest it as a hedge.

"Gold remains a classic contrarian investment. After a debilitating 20-year bear market terminated in 2001, investors remain generally disillusioned," said Angus Geddes of tipsheet Fat Prophets which predicts it will reach $US850 an ounce within five years.

For once, residential property, especially in Sydney, must also count as a contrarian investment.

DOGS OF THE DOW AND DINGOES DOWN UNDER

The trouble with contrarian investing is you have to be ever so patient.

However, there is a fast-forward version that finds the stock for you and promises a return in just 12 months.

It's based on Dogs of the Dow. This is an investment strategy whereby equal amounts are spent on those 10 Dow Jones Industrial Average stocks with the highest dividend yields.

Because there are only 30 stocks in the index, they are necessarily blue chip and therefore make for stable dividends. This means the price must have plunged to produce the high yield.

A year later stocks that are no longer in the top 10 yields - either because the price has risen or something cheaper has come along - are sold. New stocks which have fallen out of favour for some reason are bought.

Barking mad? No. When the strategy was back-tested to 1973 it was found not only to have legs but wings as well.

Over a 17-year period, the dogs returned an annual 17.9 per cent compounded, compared with the overall Dow return of 11.1 per cent.

The United States investor site Motley Fool (www.fool.com) found that over a 30-year period the dogs were more than twice as good as the rest of the market.

While it seems to work over time, it's not a winner every year.

In a rare setback, the dogs only gained 4.4 per cent last year. This was just below the Dow's 5.3 per cent, but then they gained 28 per cent the year before.

If anything, Dogs of the Dow works even better here.

Aspect Financial found that over 10 years the, um, dingoes beat the top 50 stocks by 8 per cent a year.The strategy:Choose the 10 highest-yielding stocks from among the top 50, excluding resources and trust funds.

After a year sell those that have dropped out, add any new ones in the top 10.

The stocks are: Amcor, BlueScope, Commonwealth Bank of Australia, IAG, National Australia Bank, Qantas, St George, Tabcorp, Telstra and Westfield.

Advantages

• Easy to follow strategy
• Low maintenance
• Only takes 10 or 15 minutes a year
• Tax effective
• Automatic portfolio re-balancing in 12 months
• Suits DIY investors

Disadvantages

• Not a foolproof theory
• Excludes resources stocks
• High brokerage costs
• Produces a portfolio overweight in banks
• Approach is too short-term
• Too mechanical

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