Alastair Mundy (pictured), who heads up the Investec UK Special Situations funds, says investors should start by avoiding companies with weak balance sheets, diversifying their portfolio widely, ignoring noise in the market place and most of all by being patient. “A contrarian investor has to be happy to be doing something different than the consensus. You have got to be comfortable with an uncomfortable trade, particularly because at some point you're going to be at a loss,” he said.
“We start from the premise that fund management is really difficult and there is so much information and so many people trying to outperform each other that claims they are more intelligent than each other or can use the information better is doubtful.”
“Our best chance, we think, is to also wait for the smart people we are competing against to do stupid things and that normally happens when they are under pressure.”
“For example, when a manager holds a stock that's not doing well - that they bought for good reasons - they are sitting on a portfolio with this stock embarrassing them.”
“The easiest thing to then do is to sell it and make a loss. That is a capitulation and a subjective heat of the moment decision, so we look at it more objectively and have the chance of making a better quality decision - not always, but we have a better chance.”
Mundy defines an out of favour UK stock as one that has fallen at least 50 per cent from its peak over the last seven years, excluding the last two years.
“The fall could be for any number of reasons or combination of reasons, but there are always reasons.”
“We then decide if the investors are wrong and right and why they bought it in the first place.”
“And then we look to what we can expect into the future and what will people pay for it in the future which becomes our price target. We repeat this for every stock we hold.”
“We are willing to hold on to them as long as we can still see a 40-50 per cent upside.”
He says investors can protect themselves by avoiding companies with weak balance sheets, management who use dubious accounting practices and fast moving industries.
Investec UK Special Situations has returned 223.33 per cent since taking over the fund in 2002. It has outperformed both its IMA All Companies Sector average of 157.08 per cent and benchmark rise of 169.97 per cent, over the same period.
Performance of fund vs sector and benchmark over 12yrs
Source: FE Analytics
Julian Chillingworth, who runs the Rathbone Recovery Fund alongside Marina Bond and James Baker, says a contrarian investment is one that you believe has unrecognised value which may or may not be recognised by the market.
“What makes a contrarian investment different from a poor stock has occupied investors from Warren Buffett to Graham and Doddsville and down,” he said.
“It could be that the stock is undervalued because the asset value in the business is not recognised by the market place or that people misunderstand the business model and it is considerably more profitable than the market place believes or that it can grow profits faster than the market thinks.”
“This would be the three things we would look to when looking to make a contrarian play.”
“Particularly you'd be looking at cash flow generation and the potential to boost the cash flow and that comes back to business model.”
“Cash might recently have been used to expand the business win which case you might expect an increase in the dividend returned to investors in the future.” First of all, Chillingworth (pictured) says he looks for companies trading on a discount to net asset value and a company’s cash flow generation.
“Then we see if there is any substance to it, it may be that the asset value is incorrect.”
Chillingworth says this was the case with the fund’s largest holding Booker, which it has held since the fund’s launch in 2009.
“The incoming chief executive officer of Booker spotted the opportunity, consolidated the business and expanded it, bringing it to a wider audience, but the market hadn’t seen this.”
Booker has returned 359.72 per cent over this period compared to a rise in the FTSE All Share of 93.54 per cent.
Performance of stock over 4yrs
Source: FE Analytics
Since the fund launched it has returned 127.2 per cent, beating its IMA All Companies sector average of 100.84 per cent and a rise in its benchmark – the FTSE All Share – of 93.54 per cent.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
Both managers agree on one thing in particular: investors cannot plan for anomalous risk such as those posed by politics.
“Political risk can always get in the way, for example with the energy companies,” said Chillingworth.
“If a party leader such Ed Miliband stands up and says he will freeze energy prices then the stock prices will drop like a stone.”
