Resisting peer pressure, adopting a longer time frame and picking stocks with a sustainable, competitive advantage are just some of the keys to success when it comes to building a contrarian portfolio, according to Mike Clements (pictured). 
The FE Alpha Manager, who heads up the Oyster Continental European Selection fund, adopts a bottom-up stock selection process and aims to buy into firms that can survive all market conditions and have a sustainable competitive advantage.
Many investors have been risk averse over recent months, given high levels of political uncertainty due to the EU referendum and the impending US general election.
This, combined with the ongoing hunt for income, has led to investors piling into fixed income assets and causing yields to drop to historical lows as a result, with 10-year gilts yielding 0.74 per cent and 30-year gilt yields yielding 1.46 per cent.
Performance of indices in 2016
Source: FE Analytics
With yields so low though, another favourable area of the market for investors have been ‘bond proxies’ or stalwart, dividend-paying mega-caps which are often trading on high valuations. Generally speaking, a large number of investors have bought into equities across the board given the low returns being generated by holding cash or bonds.
With markets performing so strongly at the moment, many investors may be looking to go against the grain and build more of a value-based portfolio. This is arguably no mean feat given the number of geopolitical and macroeconomic risks on the horizon.
However, Clements says this is the best way to generate returns so long as investors conduct thorough research into each individual company.
“Buy low, sell high. This investment strategy is the only way to outperform the market in the long run. It requires an understanding of why good companies are sometimes undervalued, so 'hidden gems' can be distinguished from 'value traps',” he said.
“A longer investment horizon must be adopted in order to give good investment ideas the time they need to pay off.”
The manager’s investment process appears to have worked so far, given that Oyster Continental European Selection – which was launched at the end of 2014 – is in the top quartile for its total return over the last year as well as over one, three and six months. On an annualised basis, it is in the top quartile for its return in 2015 as well as year-to-date.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
In the below article, the manager lists his five steps to achieving a successful investment outcome through a contrarian portfolio.
Widen your time horizon
When Clements and his team are selecting stocks, they will initially look at a company’s balance sheet strength, competitive dynamic and cash flow over an entire cycle.
“How can one get ahead of the herd? One way is to have more information than the competition, but in this age of instant information, it is either impossible or illegal,” the manager said.
“Another option is to do a better job at analysing information, but this is also a challenge due to the sheer volume of research. Therefore, the only realistic way is by adopting a longer time horizon in order to allow good ideas time to come to fruition.”
Patience is a virtue
Oyster Continental European Selection consists of stocks the manager deems to be attractive over a period of at least three to five years. These are generally chosen regardless of the economic cycle, which means some stocks may initially be underperforming when they are added to the portfolio.
“The adage 'buy low and sell high' sounds easy, but it hides a painful truth: buying low is easier said than done,” Clements admitted. “It requires courage to resist peer pressure and avoid fashionable, but expensive, stocks. It can also entail buying stocks nobody likes or investing in times of panic.”
“Above all, investors should be patient. This requires homework and waiting for a good entry point. Then waiting again, sometimes years, until the market changes its mind.”
Avoid value traps
While this is perhaps easier said than done, Clements believes there are indeed ways to minimise the risk of buying into value traps.
For instance, his team actively seeks weaknesses each potential investment idea and will not agree to buy into the stock until all potential queries and doubts have been answered sufficiently.
While it can therefore take the team a long time to find a stock it wants to hold in the portfolio, it correlates with the fund’s long-term time horizon.
“Unfortunately, cheap stocks can stay cheap for a long time. What your investors will never accept is to see your 'hidden gems' turn out to be 'value traps',” the manager said.
“The way to avoid this is through forensic and demanding analytical research and in-depth 'worst-case scenario' simulations.”
Identify sustainable competitive advantages
As part of his investment process, Clements seeks companies that are at a competitive advantage in their respective fields compared their peers. However, the manager needs to be confident that these advantages aren’t easily replicated by competitors and can be maintained over the long term.
“The two key rules to selecting the right stocks are quite straightforward. The first is to buy high-quality companies; the second is to buy at attractive valuations,” he said.
“What makes a company good? If you are going to invest for the long term, you need a business that has a fundamentally sustainable competitive advantage.”
“This can mean a strong brand (LVMH), market dominance and pricing power (Legrand), low cost providers (Easyjet), or technological advantage (Sanofi).”
Clements adopts a primary focus on free cash flow generation as he says this metric is less susceptible to accounting manipulation and is the main driver of a company’s wealth creation.
Understand why it is cheap
While market overreactions and shifts away from entire sectors without individual stock analysis can provide opportunities, Clements points out that many stocks are indeed cheap for a reason.
“Unfortunately, good companies generating a lot of free cash flow that are attractively valued do not grow on trees. It is therefore important to understand why at times this may be the case,” he explained.
“There are basically three possible reasons: negative investor sentiment towards a country – as was the case for Spain after 2008 – or sector; negative sentiment due to cyclical or 'flight to safety' reasons; or company specific fears around its business model.”
“Once the reason for the cheap valuation is determined, you can then assess whether it is justified or not.”