Investing style affects the outcome of your actions, while every investor has a unique strategy of parking funds in any investment avenue. Most of the investing world follow idols and their styles. Among these investing styles, value investing is one of the most popular investing styles that seeks to acquire companies at prices lower than the intrinsic value with a margin of safety.
In this article, we attempt to discuss the contrarian and counter cyclical investing styles. We shall start with a remark from Charles Mackay in his book ‘Extraordinary Popular Delusions and the Madness of Crowd’
Contrarian investing; riding against the tide.
In this type of investment style, market players usually favour stocks that are neglected by the investor community at large. They happen to buy when most of the investors are selling and sell when most of the them are buying.
At the time of market crashes, the good companies get sold along with the poor ones, which often leads to significant undervaluation in the good businesses. A contrarian investor would capitalise on such opportunities by taking positions in the robust businesses, with stocks trading at prices below the intrinsic value.
One must remember that poorly managed franchise may appear attractive at lower valuations, but the fair value of the business could still be even lower at the lower valuations. On the contrary, a well-managed high performing franchise may appear expensive at given valuation, however, the fair value of the business could be much higher than the given valuations.
Contrarian investing seeks to benefit from the mispricing of securities in the market by estimating fair value of the business and comparing it with the current price. Since security prices fall severely in a recession, which we are experiencing now, contrarian investors look for opportunities to buy businesses with strong balance sheets and decent business models, at lower prices..
In contrarian investing, the investors have long term investment horizons that allows to look beyond the crisis and into the future of the business. A long-term approach enables an investor to look beyond the short-term implications and ascertain the intrinsic value of the business effectively.
A contrarian investor seeks to identify the implications of current economic environment and analyse the impact on the businesses prior to the large number of market participants.
Proactive thinking and execution of ideas at an early stage remains a key for contrarian investors to be successful in approach as widespread detection of the idea will likely result in herd behaviour among the market participants.
Usually, contrarian investors do not follow research and ideas of others and focus on their own ideas. Opinions are always floated at widespread scale and sometimes opinions impacts your process, which is why contrarians tend to neglect the widespread ideas/opinions.
Counter cyclical investing; swimming with life jacket on.
Counter cyclical investing refers to investing in companies that underperform when economy is growing and outperform at the time of economic contraction. Usually, these companies would involve defensive businesses that have sustainable cash flows and non-cyclical nature of business.
Since counter cyclical stocks typically underperform during economic expansion which boosts investor confidence and markets, these stocks are largely neglected by the investor community as there could be opportunity cost associated in investing in counter cyclical stocks when an economy is booming.
Cash flows of the business, which are crucial for the going concern of the entity, should exhibit extreme resilience in counter cyclical businesses. Such businesses are often protected from the downside in markets due to the defensive proposition, serving as a kind of hedge in the portfolios.
Balance sheet strength is also one factor that should be monitored carefully when investing in counter cyclical stocks. Since investors are unwilling to invest in counter cyclical stocks at the time of recovery, the capital needs of the business may experience hardships.
As counter cyclical businesses include defensive companies, the investing ecosystem traditionally is limited to sectors like consumer staples, healthcare, utilities, telecommunications and real estate. However, the emergence of COVID-19 has raised serious questions for real estate sector as a defensive business.
Sometimes these businesses are often referred to as bond proxies due to the sustainable dividends, which are dependent on cash flows. Still, one must have to consider the leverage in the business as a higher level leverage would lead to lower level free cash flows to equity, thereby dividends.
One also needs to be cognizant of market cycles and economic cycles before investing into counter cyclical stocks. Interest rates have been on a lower scale for the most part of the last decade and continue to be even lower at present. it is also likely that interest rates would be lower for longer since unemployment is soaring across the world.
When interest rates are lower, the yield savvy investors may not find enough pockets to deploy capital for an attractive yield – which is why – the bond proxies or counter cyclical stocks could be an option for a sustainable yield.
While markets have eroded substantial wealth as a result of crisis, the confidence of investors that have not seen market cycles get suppressed. Some new investors that had entered the markets before the market crisis may not return to investing ever because of the poor experiences.
Since markets are like a poker game in the short term, and wealth building machines over the long term, the investors should understand that rationality and emotional control will likely pay off big over the long term.
As an investor, one should consider having counter cyclical as well as contrarian investing approach. Although both of the investing styles are somewhat similar, the ability to derive favourable outcomes depends upon the conviction, due diligence, agility etc.
Acting rationally and believing in your process would also help you navigate the markets effectively when there is so much noise around. There will be up and downs, losses and gains – you have to be true to your process and believe in yourself.