How to master a contrarian approach

Q. Why is risk management important?

A. Within the substantial growth of the asset management industry over the last 20 years have been little pockets of phenomenal growth. Areas such as compliance, hedge funds and marketing have grown faster than any sane forecaster would have predicted. What benefits each of these has brought to the end investor are questionable.

However, one area that has grown from cottage industry to behemoth in that time is risk management. Once clever software packages became available allowing asset management businesses to assess if everything was under control it was impossible to put the cat back in the bag. "Shall we do less risk analysis?" is an unlikely vote-winner.


Q. How does balancing risk management work in the context of stock selection?

A. Either implicitly or explicitly, we are aiming to calculate probability weighted, or risk adjusted, upside, for all the stocks in which we invest. Thus the portfolio’s largest positions at the time of initiation may not be the companies that we believe have the greatest potential upside, but have the best combination of potential upside and downside protection.


Q. Does your holding period make a difference?

A. Value investors are known to have a tendency to buy too soon and sell too soon and we are no exception. For this reason, we are patient when building up a position. Our sell discipline is purely value driven and therefore there is little we can do to prevent ourselves from selling too soon if a stock subsequently re-rates beyond our assessment of intrinsic value. All our analyst recommendations come attached with price targets – by sticking to these targets we accept the possibility that they be superseded by it being "different this time", but experience has taught us to be wary of such doctrines.

In practice, we tend to begin reducing exposure as a stock nears intrinsic value – from a risk management perspective, it would be counter-intuitive for our largest holdings to be the ones with the least-expected upside. Upon reaching intrinsic value, we terminate the position. In general, we aim to buy stocks that have a 50 per cent margin of safety between where they currently trade and where we believe intrinsic value lies, although we will adjust this depending on our view of the riskiness of the individual stock.


Q. What does this mean in the context of portfolio construction?

A. The screen forces us to be patient as to what we can buy – we are also patient after we have bought, with an average holding period of between three and five years. Our metronomic process of looking at individual stocks, buying them and then holding onto them, means that the portfolio at any one time will represent a collection of "vintages".


Q. How about performance as an indicator of portfolio risk?

A. Some clients might use performance as a short-cut to assess portfolio risk. After all, a fund manager who consistently outperforms his peers must, in their eyes, be doing a lot right. Unfortunately, the best fund managers over medium-term periods can prove particularly dangerous. A number of funds that have blown up over the years have historically done so after a strong period of performance. It is almost as though these managers have convinced themselves they can control absolutely anyone at their parties and have therefore taken to creating increasingly bizarre guest lists. Eventually, the party goes horribly wrong.


Q. Why do you take a contrarian approach?

A. For us, our approach is part of our overall value/contrarian strategy. Despite the wealth of evidence pertaining to its efficacy, stretching all the way back to Graham and Dodd in the 1930s, the premium returns of such a strategy have yet to be arbitraged away. Warren Buffett has previously commented on this: "I have seen no trend towards value investing in the decades I have practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult."

We think this a little harsh – it is not that humans are perverse, but that they are human. Being contrarian is simple, but not easy.