Taking on the herd mentality

Taking on the herd mentality

Investing, and particularly contrarian investing is often described as being ‘simple, but not easy’. The simple part is straightforward. One waits for a share price to fall, carries out some due diligence to check for any hidden nasties, checks the stock is cheap on some sensible assumptions and then buys the share. And if everything goes to plan, the shares, as they recover, will attract the attention of other investors and provide the original investor with a handsome profit. 

The ‘not easy’ part is where the sweating begins. A stock only tends to fall if investors have some concerns about a company’s future. There may be issues over a company’s indebtedness, accounting, industry exposure or some purely idiosyncratic issue and virtually all of the time it is perfectly rational to hold these concerns. And in many cases history tells us it is correct to have such concerns as worst case scenarios can often play out (of which a recent example is Carillion). 

But a more dispassionate assessment of history tells us that on the whole these worst-case scenarios are a fairly rare species. They just tend to stick more in investors’ minds than those stocks which do recover.

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What can often be worse than the embarrassment of holding one stock that does very badly is holding a portfolio of stocks which, in general, are doing reasonably badly. This typically happens in markets which are influenced by a significant and prolonged theme – such as the TMT bubble in the late 1990s and the mining bubble in the mid-noughties. At such times equity markets can become bifurcated with a group of stocks heavily in-favour and the rest unloved.

We have been in one of these times over recent years. The belief that inflation will remain low for an extended period of time has seen interest rates fall to extraordinarily low levels, and this has created a number of market-wide effects that have worked against us. By reducing the discount rates that are applied to equity earnings, lower interest rates have disproportionately favoured more highly-rated quality/growth stocks which have a greater proportion of their value further out in the future.

Key points

  • Contrarian investing is described as 'simple but not easy'
  • Holding a portfolio of stocks doing badly can be embarrassing
  • To remain rational the investor should seek opposing views

I have been on the wrong side of things and am seated firmly on the naughty step. I have been sitting there for so long now, that I am starting to leave an impression.

So what to do? There are three options. Option one is to simply capitulate – admit that the world has changed, that the old rules do not work and to embrace the dark side. Option two is to sit tight, accept one’s portfolio is significantly different from the market and trust that eventually themes (however strong the story) will reverse. Option three is to break the first law of digging holes made famous by Dennis Healey, the Labour politician, who opined that, "If you find yourself in a hole, stop digging". If the bifurcated market throws up increasingly attractive opportunities, surely it is right to keep buying?

At this point, the career risk that Jeremy Grantham, founder of GMO, has often talked about becomes relevant. It stops being how long the fund manager can take the pain of underperformance and morphs into a discussion on how long the client is willing to take the pain of underperformance.