Reducing the Pain of Contrarian Investing

Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and I'm joined today by James Montier, Head of Asset Allocation for GMO.

Hello James.

James Montier: Hi.

Wall: So I have just heard your really interesting talk on contrarian investing. And you told us an anecdote which is apparently contrarian investing causes you physical pain.

Montier: There is a great brain study by Eisenberger and Lieberman. They set up a computer game where they managed to simulate social exclusion. So you had three players playing except two of them were computer and at one point they dropped playing with the one person who is involved.

And they were scanning people's brains when they were doing this. And what they found was that the parts of the brain that respond to that exclusion, that being ostracised were exactly the same parts of the brain that effectively light up when you feel real physical pain. So being contrarian, following a value based approach is in essence like having your arm broken on a really regular basis.

Wall: We all know it's hard, we like to have a sheep, a herd mentality. We don’t like to stick out from the crowd. But that’s taking, illustrating how extremely difficult it is. So how do we overcome that difficulty in order to be successful investors?

Montier: That’s the real challenge, it requires a couple of different things. I think it requires an institutional framework that supports it. Because it isn’t just about human behavior it’s the combination of our behavior plus institutional impediments and therefore if you can remove the institutional impediments then you can worry about the behavior. From a behavior point of view I think there are a number of ways you can really seek to turn your behavioral short comings into advantages.

Danny Kahneman has a wonderful expression which is, if you cannot de-bias, re-bias. And people think it's very easy to stop behavioral problems. It's not. They are a byproduct of way the brain works. So they are engrained.

So rather than try and stop them the better way dealing with them is turn it to your advantage. So I think a really useful thing for a contrarian to have is valuation framework. Because that forces you to behave at a certain point in time. So let's say 2007 if you are using a valuation based framework. You look to the world and it looked hideously expensive, there was just no opportunity why would you want to invest in that world. You should have been sitting in a lot of cash and dry powder.

Conversely by 2009 the opportunity set was looking very rich, everything was really cheap, and so we were very excited as investors. The advantage of having that framework is it's a first step it forces you to say, well these things are cheap why am I buying them. The reason not buying them of course and reason they got cheap is because every newspaper is full of stories saying world could end tomorrow and it's perfectly plausible that it could. But ultimately you have to say, well I'm going to bet the percentages, I'm going to go with the forecast framework we have, which says these things are cheap.

Wall: Because whenever an asset class or even a particular fund has a fantastic year, of course it's the following year where you see incredible inflows into the asset class or individual fund. So what you are saying then is actually we need to remove the emotion from investing. We need to all become robots.

Montier: Yeah, exactly. It's really hard to do. So John Templeton used to do all of his work on what he called cold days, when there wasn’t anything happening in the market. He'd do his analysis and say okay I think this stock is worth X. Because he knew on a hot day when things were falling apart in the market he wouldn’t have the discipline to do that. I think that’s another really good call it pre-commitment strategy. Do your work when you are not feeling emotional. So that when you are it doesn’t matter because you've already have done the work and you have got there and say well I think intrinsic value is this. The only thing that has changed is price therefore I should be reacting to this.

Wall: James thank you very much.

Montier: My pleasure. Thank you for having me.

Wall: This is Emma Wall for Morningstar. Thank you for watching.