Today, I want to talk about the concept of contrarian stocks, and why they’re an important counterbalance to any investment portfolio. To get there, I want to talk about the ground-breaking economist John Maynard Keynes…
Newspaper Contests and “Crowded Trades”
Keynes made a fortune in the stock market in the 1920s, and after losing most of it in the 1929 market crash produced an even larger fortune in the 1930s. One of his many bright observations was that investing is a lot like a newspaper beauty contest, in which the readers who chose the most popular candidate are awarded prizes.
Winners are not the ones who select the candidate they personally judged to be the most attractive. Rather, the most successful strategy would be to pick the candidate that they believe the majority of the other judges would select.
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One can readily see the connection to investing. Today, with Keynes’ successful strategy widely used, investors often select the stocks that others will agree are the most attractive. As more investors come to this conclusion, particularly as the underlying fundamentals and surrounding narrative support the shares, the stock will continue to become more popular. This drives the shares ever upward in a self-reinforcing cycle.
Helping to fuel this upward advance are the short-term performance incentives of professional money managers. These investors, particularly hedge funds, receive bonuses based on their quarterly and monthly returns. As few of these managers can withstand repeated underperformance, they have a strong motivation to “buy what’s working.” And, with the fiscal year-end approaching (September 30 for some, December 31 for most), professional investors may start to scramble to make up for weak performance before the annual measurement clock runs out. This inevitably leads them to shift their vast funds toward the popular stocks.
In a year when the stock market has split into “digital economy” winners and “physical economy” losers, this effect may be particularly powerful.
We are seeing this shift into popular trades today, with the remarkable surge of stocks like Amazon (AMZN), Microsoft (MSFT), Apple, (AAPL), Facebook (FB) and Alphabet/Google (GOOGL/GOOG). These are comfortable, easy-to-own stocks – not least because they continue to march higher, but because they are also supported by rapid profit growth and very favorable secular trends.
Sell-side brokerage firms bolster this popularity with their ratings. Just one example: 29 of the 34 brokerage firms that cover Amazon.com rate it as a “Strong Buy,” according to Zacks, a firm that tracks ratings. Four of the five remaining firms rate it as a “Buy.” No firm rates it below “Hold.”
At some point, however, popular trades become crowded trades, and then over-crowded trades. Brokerage firm Bank of America publishes a monthly global fund manager survey that lists the most crowded trades. In July, for the third consecutive month, the most crowded trades are in tech stocks and growth stocks, with a record-high 74% concluding that the trade is crowded.
Crowded stocks can continue to surge long after they become crowded. Yet, eventually (and “eventually” always arrives), some change – maybe their growth decelerates or some macro factor like rising interest rates changes the narrative. In crowded trades, when selling starts there are few investors interested in stepping in as buyers. Falling prices beget falling prices as investors scramble to preserve profits.
Hence, the Need for Contrarian Stocks
Just as there can be a place in individual portfolios for these exceptionally strong tech and growth stocks, investors might also want to sprinkle in a few contrarian names to provide balance. These stocks are out-of-favor (the opposite of crowded) but often have stable (if boring) fundamentals and unusually low valuations. If the market’s crowded trades unwind, these stocks can not only help offset price declines elsewhere but may also rebound as the market re-discovers their merits.
Where are the attractive contrarian stocks today? According to a Bank of America survey, banks and energy stocks are the most heavily out-of-favor stocks. We agree that these two groups are unwanted by investors. We also see many stocks in other groups that are equally out-of-favor.
Selectivity is critical in choosing contrarian stocks. Some are no more than value traps, in which the stocks appear inexpensive but where decaying fundamentals will eventually threaten the company’s future. Energy sector stocks are heavily exposed to this risk. A few contrarian stocks have steady-enough fundamental underpinnings to see a better future.
As the chief analyst for the Cabot Undervalued Stocks Advisor letter, I focus on finding the contrarian stocks that have steady fundamentals to provide enduring value at out-of-favor prices. Today, we added a well-known consumer products company that investors continue to bypass despite its steady fundamentals and highly-discounted share price.
To learn its name, and what other value stocks I’m currently recommending in my Cabot Undervalued Stocks Advisor, click here.
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