Contrarian Investing the Right Way

By Daniel Needham President and chief investment officer, Morningstar Investment Management

"The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone is agreed about its merit, the investment is inevitably too dear and therefore unattractive." -John Maynard Keynes, Letter to Jasper Ridley, 1944 Contrarian investors are most active—or stand apart from the crowd the most—when we believe markets to be the least efficient. Like Warren Buffett, I believe markets are frequently efficient, rather than always efficient, which means that it's possible for active managers to outperform, albeit difficult. The key is to identify environments where market efficiency drops—that is, when investors are behaving irrationally. As valuation-driven investors, we base that identification process on fundamentals and discipline.

Valuation always matters, but certain environments offer riper opportunities, especially with multi-asset investing. Contrarianism helps us define when markets may be less efficient, which should help us be ready to act on our fundamental convictions and be on the right side of the trade.

Diversity in Markets Michael Mauboussin synthesized research on complex adaptive systems, market efficiency, and diversity into clear expositions for investors.1 His work links a familiar concept relating to the effectiveness of group decision-making by James Surowiecki (The Wisdom of Crowds) with the insights on the power of diversity of Scott Page (The Difference). The key takeaway: Groups perform better than the average individual would alone. As Page defines it, "the wisdom of a crowd is equal parts ability and diversity" and "the crowd predicts better than the people in it." Markets are an example of the wisdom of crowds.

In well-functioning markets, investors behave and think independently. “Well-functioning” means the conditions exist for the wisdom of crowds: diversity of decision-makers (many investors using different approaches, acting independently); aggregation of the decisions (exchanges aggregate investor views into prices); and incentives for decision-makers (rewards for generating excess returns). Important elements of diversity are independence and heterogeneity. These requirements are less onerous than those of traditional finance, as they don’t need rational investors to set prices provided they are independent, and there’s no assumption of limitless arbitrage. The opposite of independence is dependence and homogeneity of investors. This is central to our understanding of contrarian opportunities and market pricing, and an important element of herding.

The Wisdom of Bees "Herding" means an alignment of thoughts or behaviors of individuals in a group.2 Animals and insects provide illustrations. For example, as Thomas Seeley outlines in Honeybee Democracy, the collective behavior of honeybees is more complex than the behavior of individual bees. When a bee colony outgrows its hive, the queen and a swarm move to a nearby location, normally a tree, to begin the search for a new home. Hundreds of scout bees fan out over the area and return to report to the swarm by dancing. Attributes of the dance—primarily the number of circuits danced—inform the bees of the location and quality of the sites. Over a couple of days, the scout bees narrow down the choices. When a site has won over about 15 scout bees, a quorum has been reached. The other scout bees get on board with the choice. The swarm is led to their new home. Seeley found that this process continually led the bees to pick the best site for their hive.

The collective intelligence of a swarm of bees is able to harness independent evaluations of sites to find the best outcome. Seeley describes this as the right mix of interdependence and independence.3 Nature has found an optimal mix of the two through evolution. Independence Lost Scientists have tested a similar phenomenon in humans based on music downloads.4 In this experiment, people downloaded and rated songs. One group was provided the songs to download to evaluate independently, while a second group was provided aggregate download information indicating how popular each song was. The bad news for the human subjects was that they failed the independence test that bees have mastered: The group with the download information was heavily swayed by the crowd. The less independently people behave, the more likely they mimic the behavior of others. This is herding.

Back to investing: When like-minded investors buy the same asset for the same reasons, investors with different views sell. When buyers outnumber sellers, prices rise. Rising prices eventually destroy the diversity of investors, which Mauboussin refers to as a movement from the wisdom of crowds to the madness of mobs. Investors err in the same direction, and contrarians look to take advantage.

Synchronicity An interesting dynamic occurs when the breadth of investor types narrows. The depth of ownership rises among investors still in the market, such that there are fewer types of investors but more widespread ownership by the majority. Here, the idea of "markets as effective price setters" comes under pressure as more like-minded investors use similar decision rules, influenced by each other and not offset by other investors.

The key loss of breadth, in our opinion, is the loss of a particular type of investor, a group that includes value investors, rebalancers, option sellers, liquidity providers, and contrarians. These are the more price-sensitive and countercyclical investors—they tend to sell after prices rise and buy after prices fall. They also tend to be the agents of negative feedback,5 helping to keep prices in a rough band around intrinsic values.

As the types of owners dwindle, the size of the remaining ownership per shareholder rises, and investors start to synchronize at scale, behaving in similar ways. This leads to crowding, herding, mispricing, and fragile markets. Influence gives way to replication. Rising prices lead to increased trading activity, forming a positive feedback loop. The situation becomes less stable as the pool of potential buyers declines.

In bubbles, fewer types of investors remain in the market, while the number of investors willing to own the asset at the current price rises. This is where the concept of narrow breadth, or crowding, can be misleading. The great bubbles involve widespread ownership. The contrarian minority mainly sits it out, with a limited number taking the other side. All bubbles require a loss of diversity or synchronization of investors. As markets are adaptive, investors receive positive rewards from the markets for their behavior.

A Contrarian Checklist When dealing with the complexity of investing, market efficiency, and behavioral biases, it helps to use a checklist.6 The one that follows isn't exhaustive—other important items like liquidity, issuances, and short positions could also be considered. But it's a good start. We look for:

1. Concentrated ownership and unbalanced investor flows.
2. Negative cash flows or earnings expectations relative to history and similar assets.
3. Negative sentiment as gauged by investor surveys.
4. Low trading volume or turnover.
5. High and rising realized and implied volatilities.
6. Low valuation ratios relative to history and similar assets.

Looking for Mispricings Crowding, herding, bubbles, and crashes are evidence that investors are not always rational and markets are not always efficient. The infrequency of these events highlights that markets generally do a pretty good job pricing assets. But when diversity declines and large groups of investors synchronize, it's time to look for mispricings. As contrarian investors, we tend to be in the minority, both when markets are overpriced and oversold.

But being contrarian for the sake of being contrarian is as likely to lead you into investment errors as it is to get you booted off invitation lists for parties. Just because something is unpopular doesn't make it a good investment. Combining contrarian thinking with in-depth fundamental analysis and estimated intrinsic value is critical. The best investments are often those that are out of favor because of serious but temporary and recoverable issues. Searching in unpopular areas of the market certainly doesn't guarantee success, but we believe it is a good way to find opportunities. 1 See these works from Mauboussin: 2007. "The Wisdom and Whims of the Collective." CFA Institute Conference Proceedings Quarterly, Vol. 24, No. 4 (December); 2007. "Explaining the Wisdom of Crowds," Legg Mason white paper, March; (with Dan Callahan) 2015. "Animating Mr. Market," Credit Suisse Global Financial Strategies white paper, February. 2 Kameda, T., Inukai, K., Wisdom, T., et al. 2015. "The Concept of Herd Behaviour: Its Psychological and Neural Underpinnings." In Contract Governance: Dimensions in Law and Interdisciplinary Research, 1st ed. Edited by Stefan Grundmann, Florian Moslein, & Karl Riesenhuber (Oxford, U.K.: Oxford University Press), Chap. 2. 3 List, C., Elsholtz, C., & Seeley, T.D. 2009. "Independence and Interdependence in Collective Decision Making: An Agent-Based Model of Nest-Site Choice by Honeybee Swarms." Philosophical Transactions of the Royal Society B, Vol. 364, No. 1518, pp. 755–762. 4 Salganik, M.J., Dodds, P.S., & Watts, D.J. 2006. "Experimental Study of Inequality and Unpredictability in an Artificial Cultural Market." Science, Vol. 311, No. 5762, pp. 854–856. 5 Unlike a positive feedback loop, aka the snowball effect, a negative feedback loop creates stability by keeping things from getting too far from the norm, like a thermostat adjusts the temperature of a room. When markets are efficient, some investors enforce negative feedback through selling fully priced or overpriced assets and buying underpriced ones. Diversity of investor types ensures diversity of opinion and approach. 6 See also Gawande, A. 2009. The Checklist Manifesto: How to Get Things Right (New York: Henry Holt & Co.).

This article originally appeared in the June/July 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.