Contrarian investing is a great option that can reap huge benefits. But it is not suited for all investors. You need to have the mettle to stand against the herd.
Contrarianism is a great investing philosophy but it requires courage. A story, credited to Warren Buffet, should drive home the point.
In 1963, the American Express brand was skewered, and its shares clobbered, due to its involvement with Allied Crude Vegetable Oil.
This is how the story goes. Amex provided credit to the company based upon the inventory of the company’s soybean-based salad oil. It turned out that the inventory, kept on container ships apparently full of salad oil, was junk.
How was that possible? The containers were filled with water
and had only a few feet of salad oil on top. Since the oil floated on top of
the water, it appeared to inspectors that these ships were loaded with
oil.
This con job, dubbed as the “Salad Oil Scandal”, resulted in Amex losing nearly
$58 million wiping out most of its equity base as its shares went into a free
fall.
Enter Buffet who saw that Amex’s competitive advantage and cash-flow generating capabilities were intact. He believed that the fears over the eventual liability were overblown. He then went one step further and spent an evening with the cashier at Ross's Steak House in Omaha. He noted that the scandal did not stop people from using their green cards.
What he then did made history. He took one huge concentrated investment in American Express. Until then, no single investment ever made up more than 25% of the Buffet Partnership. Buffett bet 40% of his investment partnership’s capital on Amex. According to Fortune, he bought 5% of the company for $13 million. He later sold his holding for a $20 million profit.
Being a contrarian investor can make you very rich, but it requires a lot of tenacity.
Around two months ago, Howard Marks, money manager and chairman, Oaktree Capital Management spoke about contrarian investing in his memo to investors. Here is an extract.
In order to be a successful contrarian, you have to do the opposite of what the herd does. And to do that, you have to diverge from the conventional cycle in attitudes toward risk. Unfortunately, most people succumb since few are above average in this regard. Markets move in response to decisions made by the majority of investors. Most investors are guilty of the sin of overreacting (and, even worse, the sin of moving in the wrong direction), demonstrating that the ability to resist the cycle is uncommon.
To be a successful contrarian, you have to:
- See what most people are doing
- Understand what’s wrong about most people’s behavior
- Possess a strong sense for intrinsic value, which most people ignore at the extremes
- Resist the psychological pressures that make most people err, and thus buy when most people are selling and sell when most people are buying
- Be willing to look wrong for a while
- Successful contrarianism requires the ability to stick with losing positions that, as David Swensen has written, “frequently appear downright imprudent in the eyes of conventional wisdom”
If the herd is doing the wrong thing, and if you’re capable of seeing that and doing the opposite, it’s still highly unlikely that the wisdom of what you do will become apparent immediately. Usually the crowd’s irrational euphoria will continue to take prices higher for a while – possibly a long while – or its excessive negativism will continue to take prices lower. The contrarian will appear wrong, and the fact that his error comes in acting differently from most people will make him look like nothing but an oddball loser.
If you can’t stand living with the embarrassment of being unconventional and wrong, contrarianism may not be for you. Rather than trying to do the difficult opposite of what the crowd is doing, you might have to settle for merely refusing to join in its errors. That would be a very good thing. But even that is not easy.
The article was first published on March 12, 2013 on www.fundsupermart.co.in
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.
