Why You Don’t Need to Be a Contrarian
Today, we discuss the myth that all great investments have to be contrarian bets. Is that really so or is there a better way?
Contrarianism
One of the most used words in investing, especially in the value investing community, is the word: Contrarian.
“Contrarian investments outperform the market.”
“The most successful investors are contrarians.”
"Contrarians buy what others fear and sell what others envy."
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These narratives about contrarianism have been repeated and reinforced over and over.
But is that actually true?
These thoughts are based on Benjamin Graham’s core ideas of value investing.
It’s based on the simple premise that when the consensus dislikes a stock, they sell it, thus decreasing the price. When this becomes a trend, it can cause stocks to be oversold, offering opportunities.
Also, to outperform the market, you have to differentiate from the market by investing differently. Contrarian investing, once again, by definition, is making sure you do that.
The problem with a dependency on contrarian takes is that the consensus is right most of the time. So, contrarian takes can be a very costly endeavor. There’s even an argument to make that it goes against value investing principles to take these bets since many of these investments are not asymmetric bets. They can offer big upside but also come with significant downside, either because of actual price decreases or because of opportunity cost.
Howard Marks has discussed the difficulty of contrarian investments in his memos. Being contrarian isn’t enough. You also need to be right, and that takes a lot of work, patience, and confidence.
Main Problems:
As mentioned above, one of my main problems is that contrarian bets often offer suboptimal risk/reward ratios. They are a game of opinions.
A very good example is the Chinese market. Investing in it in the past years has definitely been a contrarian take. And it’s an educated one that checks many of Marks’ boxes. But in the end, China is the perfect example of how these bets are a game of opinion. There are good arguments from both sides (Side 1: China is uninvestable; Side 2: China is massively undervalued).
Even if the contrarian bet turns out to be “right.” What does “right” even mean? If, five years from now, people figure out that most of their worries regarding China were wrong, would that make the contrarian bet today right?
The bet would’ve had huge opportunity costs, and the annualized return wouldn’t be that great even if Chinese companies doubled.
If a company like Alibaba, on the other hand, triples within the next two to three years, then it would be a great investment.
But what scenario is more likely? Don’t get me wrong—I’m invested in Alibaba, so I do believe in the investment opportunity. However, one must accept that this investment is about opinion. There are good arguments on both sides.
This makes it an investment with a high potential upside but a sizeable downside, too—even if it is just the opportunity cost of holding an investment that doesn’t increase for a long time.
Everything I just wrote is mostly true for large-cap investments. Large caps are monitored by dozens of analysts from the biggest financial institutions in the world. Information flows quickly, and thus, markets tend to be rather well-informed and rational.
Rational doesn’t mean that there can’t be outsized performance by a certain stock. It does, however, mean that stocks offering the possibility of high returns also come with more risks.
Asymmetric Investments
I just said that the above points are mostly true for large-cap investments. So, what’s the alternative? Invest in smaller companies.
What is the great thing about smaller companies?
Well, this is not an article bashing contrarian investments. I like the idea of contrarian investing, and I have had good returns on these bets. But if I can find a better risk/reward profile, I’ll take that opportunity.
The great thing about smaller companies is that there is no dependency on contrarianism. You can take contrarian positions, but you don’t need to.
It’s enough to invest in a growing, profitable company that is not yet on the radar of most investors. And these opportunities exist. Those are not a question of opinion (at least a lot less). They don’t need to be in a place of weakness, not even short-term, to be cheap.
They’re cheap because they’re unknown. They’re unknown because the best investors in the game, sooner or later, have too much capital to still invest there. They’re cheap because institutions cannot yet invest in them.
There are systematic benefits to investing in smaller companies.
Of course, they come with different risks. But that's a topic for another day.
These were some rather spontaneous thoughts I had on this topic. Let me know what you think.
Next week, I’ll publish my next stock pitches.
Here’s the latest one:
Have a great day!
Daniel