Nerves of steel...a contrarian iinvestor may sell up and buy again after the fall.
In the first in our series on investment strategies, Martin Roth looks at contrarian investing.
In early 2009, as stocks continued the precipitous decline that had begun in November 2008, investors needed considerable courage to ignore the trend and plunge back in to buy.
Yet March 2009 marked a dramatic turning point, with the benchmark S&P/ASX 200 index soaring more than 50 per cent in the ensuing seven months. In retrospect, it is clear that investors were being offered a spectacular short-term buying opportunity of the kind that does not appear often.
Contrarian investing - an investment that goes counter to market trends or to conventional wisdom - can bring rich rewards. But it also requires considerable experience of the market and strong nerves. It is certainly not for every investor.
In 2002, investors generally believed that the US-dollar price of gold would continue to meander in a narrow range, as it had been doing for several years. Contrarians (who thought otherwise) have seen their investment soar more than fourfold since that time.
In essence, contrarian investing involves buying a quality asset when it appears to be mispriced and too cheap and then waiting for its price to rise. It can also mean selling an asset when it seems overvalued.
For equity investors this might mean taking advantage of the fact that markets can be based on investor emotion and so can overreact - sometimes quite dramatically - on both the upside and the downside.
"It means picking up the unloved companies, the beaten-up companies, the special situation-type companies," says the senior portfolio manager for Three Pillars Portfolio Managers, Otto Rieth.
Yet some market experts say this is little more than a variation of value investing, which involves seeking out undervalued companies and then waiting for the share price to rise. Many famous investors, such as Warren Buffett, do this all the time.
In addition, it can take time for a contrarian investment to yield a profit. In the mid-to-late 1980s, as the Japanese sharemarket continued to race ahead, some financial experts began saying that the increase was unsustainable and that the Japanese market was developing the characteristics of a classic financial bubble.
But contrarian investors who bet against the Japanese market at that time were forced to watch as it leapt from one new peak to another. It was only at the beginning of 1990 that the bubble burst and Japanese stocks began their long decline, from which they have yet to recover.
A similar observation could be made about the sub-prime debacle in the US.
"A number of high-profile contrarians were quite down on the US for some time," Rieth notes.
"They were saying it was an accident waiting to happen. But they were saying this for close to a decade before the market crashed. Eventually they were right. But a broken watch is right twice a day."
The sharemarket maxim "the trend is your friend" carries a lot of truth. Markets can continue moving in one direction for lengthy periods, sometimes sustained by little more than investor enthusiasm and emotion.
According to Rieth, a contrarian investor can take a bottom-up approach - for example, examining individual stocks - or a top-down view, which could involve making a judgment on an entire market or asset class.
The portfolio manager for the Select Alternatives Portfolio at Select Asset Management, Robert Graham-Smith, describes his approach as "trying to put together a very diversified portfolio of investments that are not correlated to traditional markets and that in some cases zig when the market zags, so to speak." Though not strictly contrarian investing, this method is quite similar.
In some cases it involves the purchase of out-of-favour assets, although quite often in relatively esoteric products such as hedge funds, managed futures, private equity, commodities and precious metals.
"The attraction of some of these types of investments is that they can genuinely make money when equity markets, in particular, are range-bound or are very choppy, even [during] overextended periods," he says.
One of his investments, in the Black Swan Fund, which specialised in long-dated options, showed a return of nearly 240 per cent in 2008.
But does the relatively unsophisticated home investor have any hope of replicating such success?
"I do not want to give the impression that what we are delivering in packaged format is an overly complicated thing," he says.
"But understanding some of the underlying investments does require specialist skill and not all the investments are easily accessible.
"Although, that said, there are some areas of what we do that are available to the general public, such as listed infrastructure, some hedge fund strategies or gold."
Where might the contrarian investor be looking today for ideas?
Rieth suggests the example of China. "The bulk of the street seems to think China is going to continue doing quite well," he says. "A contrarian would say China is in a crazy credit bubble. We will find out who is right in the next six to 12 months or so."
Finally, consider the Australian housing market. Prices have continued to rise and rise for many years, despite the global financial crisis and tumbling equity markets. Low interest rates and a growing population - particularly from immigration - are generally cited as among the reasons. Today, a house in one of our major cities is more expensive - as a multiple of average incomes - than in most other big cities around the world.
Yet recently some contrarian voices have been heard. In June, the renowned US fund manager Jeremy Grantham was quoted as warning that the Australian and British housing markets were the last two bubbles remaining from the global financial crisis and he predicted it was only a matter of time before they crashed.
He said Australian house prices needed to fall 42 per cent to return to the long-term trend and predicted that "sooner or later, the [interest] rates will go up and the game is over".
A decline of that magnitude would have a profoundly negative impact on many areas of the Australian economy. It would also present opportunities. You could even sell your own home in the hope of buying another dwelling later at a significantly cheaper price.
But that is one contrarian manoeuvre that would require the strongest of nerves.
