On the Contrary

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Playing Armchair Contrarian                                                are about to embark on a long-term bull market as we did
                                                                           in 1982, when buying shares of the Dow Jones was truly a            A
Now let’s examine a few current themes for contrarian investing            contrarian move. Moreover, according to an April 26 Barron’s        C
in today’s turbulent market. I would like to preface this section by       survey of Institutional Investors (the so-called smart money), a    T
providing you with the classic cover-your-butt clause and say that I       whopping 81% of respondents are either bullish or neutral on        I
                                                                           the prospects of the stock market over the next year. This type
do not recommend you pursue any of these strategies as you will likely                                                                         C
                                                                           of sentiment is a contrarian’s worst nightmare.
lose money on them. These are simply examples and are meant to                                                                                 S
supplement this discussion on contrarian views.                            Foreign Markets
                                                                                                                                               Edition 5 . Volume 8

                                                                                                                                                         On the Contrary
                                                                           How about Japan? In 1990, the Japanese stock market began
With house prices in certain parts of the U.S. falling off the edge        to collapse. The index hit an index price peak of 39,000 and
of a cliff over the last year or so, one would automatically assume        then starting dropping like a stone. At 25,000, analysts viewed
that prices somewhere in the U.S. would appeal to contrarians.             the crisis as being over; every time the Nikkei fell, it was

                                                                                                                                                                    A Brief Look at Contrarian Investing
Maybe so, but measuring how much house prices have dropped is              viewed as another buying opportunity. But it just kept getting
not enough; one must also look at where they came from. In this            worse and worse. Today (May 2008), you can buy the Nikkei
regard, most contrarians would shy away from an asset unless it is         for 13,655 – a 65% discount from its peak.
hitting decade (or sometimes multi-decade) low prices. Houses              While Japan is full of problems with its aging demographics,
in the U.S. do not qualify. There are probably some areas in the           closed border policies, high levels of debt, and relatively low
U.S. (e.g., Detroit) where home prices are at multi-decade lows and        domestic consumption to name just a few, all of this glum news
would appeal to a contrarian, but on average they are not.                 is exactly what makes for a perfect contrarian bet. That being
Oil                                                                        said, there is at least some hope for this battered economy,
                                                                           including the fact that Japan is one of the few countries in the
Buying into oil or oil stocks at this point is most assuredly not a        world that pretty much avoided the hodge podge of sub-prime
contrarian investment. Prices have been rising consistently and            investment vehicles.
above most people’s expectations for the past eight years. Oil was a
contrarian investment at the beginning of the decade, when many
analysts were debating whether US$10 or US$20 per barrel was
the long-term price. In fact, a case could be made that oil is at          The purpose of this newsletter is not to make general or specific
multi-decade highs, so if there is going to be a contrarian view,          investment recommendations, but to make observations about
it should be bearish - that oil prices are in a bubble and poised to       how contrarian investors tend to think and to provide examples
fall. Interestingly enough, general Wall Street sentiment actually         of the types of scenarios that appeal to them. I do not pretend
expects a fairly sharp correction in the price of oil. In order to         to be a contrarian investor, although I am sure I have, in the
consider this a contrarian prospect, there must be consensus               past, unknowingly made some investments that would be
                                                                           considered contrarian. I also don’t think of this investment        By Kash Hashemi, CFA, MBA
agreement in the market and stocks must be priced accordingly.

                                                                           style as a good way to accumulate wealth for retirement.
Gold                                                                                                                                                       any years ago, as a recent know-it-all University        at low price-to-book ratios or offering a high dividend yield
                                                                           The main point is that contrarians tend to think outside the                    graduate, I optimistically embarked on a                 is a contrarian investment, which was surely not true. To no
Similar to oil (although not to the same extent) gold prices have          box. In looking for themes, contrarians prefer small probability                career search with high hopes of landing a               one’s surprise, I didn’t get the job. The good news is that life
been rising consistently since the start of the decade. Gold was           events with big payoffs and, consequently, tend to lose money       well-paying job that would make any mother proud. After              tends to give you second chances. This time, I will attempt
a contrarian investment in the early part of the decade when it            on their trades more often than they make. But unlike
was fetching less than US$300/oz. Contrarian thinker and author                                                                                more than a few interviews, it became dishearteningly                to define what it means to be a contrarian by:
                                                                           professional sports, investment success is not measured by the      apparent that it would actually require years of hard work.
of “Financial Reckoning Day”, Bill Bonner has made a name for              number of wins vs. the number of losses. Contrarian investors
himself by calling his trade of the decade in 2000, where he sold          care about the cumulative ‘score’ in each of the ‘games’ they
the Dow Jones and bought gold. It is not the end of the decade yet,                                                                            I recall one particular interview where I was asked to define what
                                                                           play, win or lose. If you can win big and lose small, then it
but it is far from the beginning.                                                                                                              it means to be a contrarian. After an uncomfortably long pause,
                                                                           makes frequent losing a tolerable price to pay.
Domestic Markets
                                                                                                                                               I remembered a small blurb from one of my many overpriced                  in this issue: SUMMARY
                                                                           With logic like that, it’s probably a good thing I wasn’t           Finance textbooks that described contrarian investing as
As for North American stock markets, the Dow Jones or S&P 500              interviewing for a position with a professional sports franchise.   “a sub-set of the value investing discipline.” I proceeded to              In the world of Finance, going against the grain
could hardly be called contrarian investments today. With trailing         Or maybe I should have become a comedian after all.                 provide the interviewer with a standard textbook answer: a                 is sometimes bold, sometimes ill-advised, but
price-earnings ratios around long-term averages and the prospects                                                                              contrarian is an investor who buys securities that are out of              usually both. So when looking at an investment
for earnings looking weaker by the month, it is unlikely that we
                                                                                                                                               favour according to some well-defined, fundamental measures,               that’s fallen out of favour or ignored by the
                                                                                                                                               such as low price-to-book ratios or high dividend yields.                  market, how does one know when it’s right to
                                                                                                                                                                                                                          buy, or even if it’s a good idea? In this edition
 A                                                                                                                                             Before I realized I had placed my foot directly in my mouth, the
                                                                                                                                                                                                                          of Tactics, Portfolio Management team member,
 C                                                     Vancouver:                                                                              interviewer dismissed my shallow response by pointing out that
                                                       Head Office: 5th Floor - 1508 West Broadway, Vancouver, BC V6J 1W8 Tel: 604-739-6450                                                                               Kash Hashemi, guides us through the discipline
 T                                                                                                                                             he asked me what it meant to be a contrarian, not what it meant
                                                       Kelowna:                                                                                                                                                           of Contrarian Investing.
 I                                                     Landmark III Suite 520 - 1632 Dickson Avenue, Kelowna, BC V1Y 7T2 Tel: 250-763-9757
                                                                                                                                               to be a contrarian investor. He also pointed out that my defi-
 C                                                                                                                                             nition for contrarian investing suggests that any stock trading
 •	 Exploring the contrarian thinker and offering a non-           What does this have to do with contrarian thinking or                             taught that the majority rules, so having a minority opinion causes           A simple example (though admittedly extreme)
    financial example of contrarian behaviour;                     investing? Solon displayed a contrarian thought process                           them to examine why they are wrong as opposed to why the                      helps illustrate this point:
 •	 Defining contrarian investing;                                 because he understood skewness: that frequent success is                          majority might be wrong.
                                                                   meaningless if failure is too costly to bear. Contrarians apply                                                                                                 Let’s consider the $10,000 purchase of a security and
 •	 Providing a simple example of a contrarian investment; and                                                                                       This reminds me of times when, after writing an exam, I would ask             assume that 10% of the time it will be profitable. Half the
                                                                   this concept by considering both the probability of an event
 •	 Examining current contrarian signs.                                                                                                              two or three of the “smart” students in the class how they answered           time it will generate a total profit of $150,000 and during
                                                                   occurring and its outcome. This is in contrast to normal
                                                                                                                                                     certain questions. If their responses were similar to mine, I would           the other half, it will generate a total profit of $300,000.
                                                                   human behaviour, which tends to ignore the very low
                                                                                                                                                     get a sense of comfort. It never really occurred to me that our               Let’s also assume that 90% of the time, this security will
                                                                   probability event (being captured by King Cyrus) regardless
 The Contrarian Thinker                                            of the severity of the outcome (being robbed of your wealth).
                                                                                                                                                     responses could be the same and incorrect all at the same time.               eventually be worth zero, thereby creating a loss of $10,000.
 In some ways, contrarians are a little like comedians in that                                                                                                                                                                     From here, we can create the potential outcomes as shown
 they test the boundaries and challenge the status quo.
                                                                   The Contrarian Investor                                                           The Math
 Comedians often go out of their way to present ideas that                                                                                                                                                                                                              100%
                                                                                                                                                     In the world of Finance, we are constantly reminded about a study
 sound absurd. Sometimes the audience laughs. Other                Very generally, the contrarian investor displays intellectual
                                                                                                                                                     done for the SEC (Securities & Exchange Commission) which                                             Security                  Loss
 times the level of absurdity exceeds the audience’s ability       independence with a large dose of skepticism about consensus                                                                                                                            Becomes
                                                                                                                                                     came to the conclusion that 90% of all options* expire worthless.                                                             -$10,000
 to comprehend what is being said, resulting in awkward            views. It is an attempt to profit by betting against the consensus.                                                                                                        90%          Worthless
                                                                                                                                                     This means that 90% of the time, the buyer of an option will lose
 silence. A contrarian thinker offers opinions that are            Essentially, the contrarian does three things:
 amusing at times and incomprehensible at others, also often       1. Watches for popular and neglected areas of the market
 resulting in awkward silence.                                                                                                                       Because of this piece of data, some very well-respected minds in                 Invest in                                    Big Win
                                                                   2. Comments on the crowd behaviour in markets                                                                                                                      Security                                    +$300,000
                                                                                                                                                     the financial industry make the claim that buying options is a
 However, unlike a comedian, a contrarian doesn’t just conjure     3. Uses a very small portion of total investable                                                                                                                   $10,000
                                                                                                                                                     losing proposition. They therefore conclude that selling options
 up absurd ideas. Normally, the contrarian’s thought process          funds to act on a contrarian investment idea                                   is a winning proposition since option trading is, by definition,
 involves the direct or indirect calculation of probabilities                                                                                                                                                                                                           50%
                                                                   Contrarian investors know that they’ll be wrong more often                        a zero-sum game (i.e., your gain is someone else’s loss and your loss                                  Security
 and outcomes in an attempt to prove that what he or she                                                                                                                                                                                                    Sold for              Small Win
                                                                   than right. They also understand that they don’t need to be                       is someone else’s gain). Sounds pretty logical, right? Actually, if                      10%                                 +$150,000
 is saying is not as far-fetched as it appears. Contrarians are                                                                                                                                                                                             a Profit
                                                                   right most of the time, because when they are right, they                         you do the math, it is not that logical at all.
 generally well aware that their ideas sound crazy, but they’re                                                                                                                                                                                                         50%
                                                                   expect the payoff will be large enough to make up for all the                     Assuming we can take the study results as fact, the idea that 90%
 also confident that their ideas aren’t as crazy as they sound.
                                                                   times they were wrong.                                                            of all options will eventually be worth zero should be meaningless.
 One of my favourite non-financial examples                                                                                                          This is because it only takes into account the probability of an              In this greatly simplified example, we can calculate the
                                                                                  The point here is that a contrarian utilizes the
 of contrarian thinking comes from the book                                                                                                          event occurring while completely ignoring the potential outcome.              expected dollar profit, since we know the probabilities and
                                                                                  state of investor psychology as a form of idea
 ‘Fooled by Randomness’ by Nassim Nicholas               Contrarians test                                                                                                    In other words, what matters is the amount            outcomes for each of the three possible scenarios:
                                                                                  generation. And here is where the contrarian
 Taleb, a brilliant book that forces you to think        the boundaries                                                                                                                         of money that was lost
                                                                                  may have a leg up, because if there’s one thing                                                                                                    (0.10)(0.50)(300,000) + (0.10)(0.50)(150,000) + (0.90)
 outside the box. The book begins with the                                                                                                                                                         90% of the time vs.
                                                          and challenge           that’s fairly predictable about markets, it’s                                                                                                                    (1.00)(-10,000) = $13,500
  story of Solon’s warning to Croesus, King of                                                                                                                                                     the amount of money
                                                         the status quo.          investor psychology. At market tops, jubilation
  Lydia. Croesus, one of the richest men of his                                                                                                                                                    that was made 10%               Here is a situation where the probability of loss was 90%,
                                                                                  turns into denial, which eventually turns into
  time, was visited by the Greek legislator, Solon.                                                                                                                                                of the time.                    but the expected outcome was a 135% gain (or $13,500
                                                                                  reality, which turns into fear, which results in
  Solon was indifferent to Croesus’ wealth and                                                                                                                                                                                     profit on a $10,000 investment). This is what skewness
                                                                                  capitulation at market bottoms. At market                                                                       *An option is a derivative
  told him: “The observation of the numerous misfortunes that                                                                                                                                                                      (or asymmetry of returns) is all about, and this is what
                                                                   bottoms, investor psychology works all the way back up to                                                                      security, a financial security
  attend all conditions forbids us to grow insolent upon our                                                                                                                                      whose characteristics            contrarian investors pay attention to.
                                                                   jubilation again.
  present enjoyments, or to admire a man’s wealth that may yet,                                                                                                                                   and value depend on (or
  in course of time, suffer change. For the uncertain future has   The challenge, of course, is that nobody knows how long this                                                                   are derived from) the            To the contrarian investor, the $10,000 investment has
                                                                   process is going to take and how high or low the crowd’s                                                                       characteristics and value        an expected profit of $13,500. Sounds good, doesn’t it?
  yet to come.”                                                                                                                                                                                   of an underlying security.
                                                                   psychology will reach. In this regard, the contrarian knows                                                                    For the purpose of this          Well, yes and no. It is a good expected outcome, but if
  In other words, “it ain’t over ‘til it’s over.”
                                                                   full well they cannot predict with certainty the exact time to                                                                 discussion, I will greatly       you back the truck up on this trade, you will be penniless
  Years later, Croesus would lose in battle to the Persian King,   get in or get out.                                                                                                             simplify the example such        90% of the time. However, if you put a very small portion
                                                                                                                                                                                                  that it is not necessary to
  Cyrus, be stripped of his riches, and concede to Solon’s                                                                                                                                                                         of investable funds to this strategy, over the long term (at
                                                                   On paper, the strategy sounds very simple. In practice, it                                                                     understand how options
  wisdom. He realized that it was impossible to be called                                                                                                                                         work.                            least statistically) you should do very well on the trade.
                                                                   requires a different mentality, one which most humans are
  the wealthiest man who has ever lived, because there was a                                                                                                                                                                       As mentioned before, in theory this is how a contrarian
                                                                   just not wired for. For one, it can be extremely uncomfortable
  possibility, albeit a miniscule one, that the wealth could be                                                                                                                                                                    looks to make money. In practice, however, it’s quite
                                                                   to be wrong and contrarian at the same time, especially when
  taken away.                                                                                                                                                                                                                      difficult.
                                                                   money is on the line. Secondly, most people grow up being

J une 200 8                                                                                                 w w w. n i c o l a w e a l t h . c o m   A Newsletter to aid business owners and professionals in obtaining their financial goals.                                        June 2008