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How to be a contrarian investor

James Henderson, Portfolio Manager of Lowland Investment Company and Henderson Opportunities Trust talks about his experiences as a contrarian investor and what that means in today’s market. A version of this article was published earlier by the Financial Times.

Labour’s pledge to halt new drilling licences in the North Sea if it wins the next election saw shares in Serica Energy sink nearly 10 per cent in a week. They’re down 22 per cent so far this year thanks to the windfall tax and anti-oil sentiment. This makes the contrarian in me twitch with anticipation.

Until we have built the necessary renewable energy infrastructure, we need gas. I would rather it came from the North Sea, where Serica is predominantly focused.

This has been a good share for us over the long term. We reduced our holdings last year when gas prices were very high but have now added again. Heavy capital spend has improved the productivity and longevity of Serica’s wells and is leading to substantial profits and dividend payouts. At the end of last year Serica had £432m of cash on its balance sheet. The current market cap is £817m.

It is easy for a contrarian investor to resemble the pub bore who always takes issue with the consensus and is surprised to have no friends. However, all the great investors have had a contrarian streak. Buying shares no-one else wants is how large fortunes can be made (and lost, too, unfortunately).

I have been a contrarian investor at different times and to different degrees for much of my career, which now covers nearly 40 years. So what have I learned and how does it apply to today’s markets?

Fight your instincts

Contrarian investing is counterintuitive. Learn to understand when your irrational instincts are screaming at you and deflecting you from a shrewd investment decision.

Following the herd is just one of our cognitive biases. Others include loss aversion. We tend to hate our losses twice as much as we enjoy our successes – so look for asymmetric risk, where the potential upside is many times greater than the downside. Confirmation bias leads us to interpret information that supports our beliefs. Actively look for evidence that might instead counter your thesis.

Biases can be magnified in a crowd. The truth is that things are rarely as good – or as bad – as you are told, so resist the temptation to buy spontaneously when you feel the urge to move with or against what the economist, Keynes, called the “animal spirits” of the market. A contrarian position can be justified only if it is built on thorough research, based on a company’s intrinsic value and strengths.

Learn to fail

Just because most successful investments tend to be contrarian does not mean all contrarian investments will be successful. The problem is that we can never be sure which will pay off.

In 1988, after a period of near-suicidal expansion and acquisitions, retailer Next was on the brink of bankruptcy. Its legendary boss, George Davies, was sacked. Its shares fell to 7p. The purchase of the Grattan catalogue had nearly killed the business; the launch of the Next Directory revived it. By November 2021 the shares had risen to over £80. Near-death experiences can bring discipline and renewed corporate focus. At 7p a share the shrewd investor could not have been sure of success but might have considered the odds in their favour and the risk asymmetric. It still required some luck.

The contrarian investor lives on a diet of disappointments, compensated by the occasional major success. You need a tough skin. And being prepared to fail means diversifying – so that if you do fail you are not punished. This is why I run portfolios with over a hundred stocks.

Be sceptical

It is not just the crowd you need to be wary of – company managements also demand a healthy dose of scepticism. When things go wrong in a business and debts are rising, company managers can be inclined to underplay the problems, thinking (let’s be generous) this is in the company’s best interests. It probably is not and it is certainly not in yours.

Contrarian opportunities today

The most obvious contrarian call today is the UK market itself, which is trading at a substantial discount to other global markets. The UK’s problems are well known – from poor productivity to bewildering political changes of direction. But problems continually articulated are problems priced in. Smaller UK companies are on the lowest valuations. A generation of new businesses with disciplined and innovative managements are emerging, like the tech-driven ad business, Next Fifteen. If they can survive in this environment they will thrive when the tide turns.

A contrarian looks beyond current problems that seem all-consuming. Housebuilders’ shares currently trade at considerable discount to the book cost of the land these companies own. Higher mortgage rates are impacting affordability, so builders are cutting back on construction – which means falling profits. But land is a scarce asset in the UK, and quality housing is in short supply. Over time, as they have in the past, good housebuilders will trade on premiums to their asset values, reflecting these long-term realities. Cyclical sectors like housebuilding can be good for contrarian investors. Buy when profits are down and remember to sell when these companies are trading strongly.

Finally, a note on timing As Keynes remarked: Markets can stay irrational longer than you can stay solvent.” Spectacular bets on commodities and currencies cost him two fortunes before he learned this lesson. The best time to be a contrarian is when the last exasperated shareholder has left the register. You cannot time this to perfection, but buying when it hurts most helps.

Buying smaller UK companies hurts now. In truth, it has hurt for some time. But experience and rational thinking tell me the brave will be rewarded. One day that bounce will come!

Glossary

Balance sheet – A financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.

Gearing – Gearing is the measure of a companies debt level. It is also the relationship between a companies leverage, showing how far its operations are funded by lenders versus shareholders. Within investment trusts it refers to how much money the trust borrows for investment purposes.

Cyclical stocks – Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.


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Please read the following important information regarding funds related to this article.

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. This is a marketing communication. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions.
    Specific risks
  • Higher yielding bonds are issued by companies that may have greater difficulty in repaying their financial obligations. High yield bonds are not traded as frequently as government bonds and therefore may be more difficult to trade in distressed markets.
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  • Active management techniques that have worked well in normal market conditions could prove ineffective or negative for performance at other times.
  • The Company could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Company.
  • Shares can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
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  • The Company may use gearing (borrowing to invest) as part of its investment strategy. If the Company utilises its ability to gear, the profits and losses incurred by the Company can be greater than those of a Company that does not use gearing.
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