Shares in oil and gas group Serica Energy are down 21 per cent so far this year due to a windfall tax, anti-oil sentiment and Labour’s pledges to halt new drilling licences in the North Sea. This makes the contrarian in me twitch with anticipation.
Until we have built the necessary renewable energy infrastructure, we need gas. I would rather it came from the North Sea, where Serica is predominantly focused, and this has been a good share for us over the long term.
It is easy for a contrarian investor to resemble the pub bore who always takes issue with the consensus and is surprised to have no friends. However, all the great investors have had a contrarian streak. Buying shares no one else wants is how large fortunes can be made (and lost, too, unfortunately).
I have been a contrarian investor at different times and to different degrees for much of my career, which now covers nearly 40 years. So what have I learned and how does it apply to today’s markets?
Fight your instincts
Contrarian investing is counterintuitive. Learn to understand when your irrational instincts are screaming at you and deflecting you from a shrewd investment decision.
Following the herd is just one of our cognitive biases. Others include loss aversion. We tend to hate our losses twice as much as we enjoy our successes — so look for asymmetric risk, where the potential upside is many times greater than the downside. Confirmation bias leads us to interpret information that supports our beliefs. Actively look for evidence that might instead counter your thesis.
Biases can be magnified in a crowd. The truth is that things are rarely as good — or as bad — as you are told, so resist the temptation to buy spontaneously when you feel the urge to move with or against what John Maynard Keynes called the “animal spirits” of the market. A contrarian position can be justified only if it is built on thorough research, based on a company’s intrinsic value and strengths.
Take Serica, which we’ve added to on weakness. Heavy capital spending has improved the productivity and longevity of its wells and is leading to substantial profits and dividend payouts. At the end of last year it had £432mn of cash on its balance sheet. The current market cap is £817mn You can’t buy without looking properly at the numbers.
Learn to fail
Just because most successful investments tend to be contrarian does not mean all contrarian investments will be successful. The problem is that we can never be sure which will pay off.
In 1988, after a period of near-suicidal expansion and acquisitions, retailer Next was on the brink of bankruptcy. Its legendary boss, George Davies, was sacked. Its shares fell to 7p. The purchase of the Grattan catalogue had nearly killed the business; the launch of the Next Directory revived it.
By November 2021 the shares had risen to over £80. Near-death experiences can bring discipline and renewed corporate focus. At 7p a share the shrewd investor could not have been sure of success but might have considered the odds in their favour and the risk asymmetric. It still required some luck.
The contrarian investor lives on a diet of disappointments, with the compensation of the occasional major success. You need a tough skin. And being prepared to fail means diversifying — so that if you do fail you are not punished. This is why I run portfolios with over a hundred stocks.
Be sceptical
It is not just the crowd you need to be wary of — company managements also demand a healthy dose of scepticism. When things go wrong in a business and debts are rising, company managers can be inclined to underplay the problems, thinking (let’s be generous) this is in the company’s best interests. It probably is not and it is certainly not in yours.
The most obvious contrarian call today is the UK market itself, which is trading at a substantial discount to other global markets. The UK’s problems are well known — from poor productivity to bewildering political changes of direction. But problems continually articulated are problems priced in.
Smaller UK companies are on the lowest valuations. A generation of new businesses with disciplined and innovative management teams are emerging, like the tech-driven ad business, Next Fifteen. If they can survive in this environment they will thrive when the tide turns.
Some sectors look particularly attractive now. I have told the story of Next. Retailing is a geared activity. There are often large, fixed costs — rents, rates, wages and stock. But the marginal cost of sales thereafter falls fast.
In slowdowns, as a result, retailers are more vulnerable than companies that can cut costs easily. The retailers I have been buying over the past year are Marks and Spencer and Halfords. I believe both are improving companies whose progress is being partially hidden by the economic climate.
A contrarian looks beyond current problems that seem all-consuming. Housebuilders’ shares currently trade at a considerable discount to the book cost of the land these companies own. Higher mortgage rates are impacting affordability, so builders are cutting back on construction — which means falling profits.
But land is a scarce asset in the UK, and quality housing is in short supply. Over time, as they have in the past, good housebuilders will trade on premiums to their asset values, reflecting these long-term realities. Cyclical sectors like housebuilding can be good for contrarian investors. Buy when profits are down and remember to sell when these companies are trading strongly.
Finally, a note on timing. Keynes’s spectacular bets on commodities and currencies cost him two fortunes before he learned his famous lesson: “Markets can stay irrational longer than you can stay solvent.” The best time to be a contrarian is when the last exasperated shareholder has left the register. You cannot time this to perfection, but buying when it hurts most helps.
Buying smaller UK companies hurts now. In truth, it has hurt for some time. But experience and rational thinking tell me the brave will be rewarded. One day that bounce will come.
James Henderson is co-manager of the Henderson Opportunities Trust and the Lowland Investment Company
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