CONTRARIAN INVESTING VS MODERN PORTFOLIO THEORY

Being a Contrarian Investor, by definition, is a lonely life. Often contrarian ideas and themes go directly against what everyone is being told by the “experts”. At LBA we avoid the flavor of the month.

Contrarian investing does not mean buying a stock or playing a theme simply because it is out-of-favor. Often a stock that is considered out-of-favor should be and therefore is sold. The Contrarian investor must make investment decisions using both judgment and fundamental analysis, and must have patience.

The Contrarian must often fend off criticism about being out of touch with the current market because he/she is not obeying what Wall Street deems “the next big thing.” The only true way to gain sound capital appreciation is to be invested in a theme prior to it becoming the next lemming run.

Trying to figure out where the future is going, and what Wall Street is or isn’t doing is a large part of the art of Contrarian investing. There are certain times when selling continues in a sector well past common sense; however, being technically right does not make you fiscally correct if your stock continues to be sold. The Contrarian must be careful to not enter an investment too early.

From a fundamental standpoint, we look for stock in companies with low debt, strong cash flows that generally translate into consistent dividend growth, that are leaders in their field, have dynamic management with diverse or necessity driven product lines, and a host of quantitative ratios that offer insight on the status of the company. While it is important to know what we look for in a stock, it is equally important to know what to avoid – often times we do not know if a company is strong or weak until we dissect the balance sheet and count the number of footnotes.

Being a Contrarian is part art and part science. But with patience and hard work, strong self esteem and lack of arrogance, the Contrarian investor is rewarded. Contrarians never rest, are always analyzing, always reading, and always learning. Having to constantly defend investment choices (after all, no news or only negative news is our playground) makes a Contrarian an even better investor. They must always be on top of their investments and what is going on in the investment world. It is a lonely life in the financial community, but it is definitely not boring and at times can be great fun.

Modern Portfolio Theory (MPT) was formed in the 1950’s, but was not popularized until the late 70’s and early 80’s, so it is not as modern as one may believe. MPT does not take into account the fundamentals of a business or industry, but rather focuses on the historical stock price fluctuations. This theory uses seemingly scientific and quantitative methods, but under further examination we find the entire premise of MPT is based on human variables and inputs rather than the quantitative certainty its pundits would have us believe.

The key hypothesis to MPT is price is equal to value, which is also known as the “efficient market hypothesis”. MPT uses “Capital Asset Pricing Model” or CAPM to create a “proper” mix of different asset class – Stocks, Bonds, Cash, etc. in an attempt to maximize a risk/reward scenario in a portfolio. As an academic exercise it is admittedly a fun thing to do (if you are a bit of a finance geek and like playing with numbers like some of us here at LBA), but looking back to see what the best portfolio would have been does no good for predicting the future. The expected return, volatilities (BETA) and correlations are all HUMAN ASSUMPTIONS and guesses!! A slight difference in one input affects the final result drastically!

MPT looks to the past to anticipate future results. LBA looks both to the future and to the past to measure how the psychology and fundamentals will change and to anticipate obstacles and opportunities. MPT attempts to quantify the human and artistic side of investing, but by doing this it puts investors at risk by lulling them into a false sense of security through qualitative measures masked as quantitative certainties.

LBA is very upfront in our belief that investing is both art and science without trying to cloud over or discount the art portion of picking good stocks. We know that a company with solid fundamentals is just as important as making sure investor, management, and global psychology reinforces these fundamentals. As an academic exercise MPT is interesting. However, disguising MPT’s human assumptions as science makes it a dangerous theory in which to place investment dollars.