It’s often observed that to be successful investors we shouldn’t buy last year’s winners. Usually this is sound advice; the top performing shares of last year often don’t continue to perform as strongly the following year, simply because there are too many factors at play that can affect the price over the course of the year and shares that have performed well don’t have the capacity to produce the same amount of performance.
But following this strategy over the last few years would have been disastrous as the winners have continued winning and the losers have continued losing. Since 2010 the same sectors have repeatedly been at the top of the performance tables.
The momentum behind these shares is incredible. We’ve seen nothing similar since the technology boom.
This time, however, the companies that have performed strongly are not exciting tech companies, supposedly on the verge of changing the world. Instead they are ‘defensive’ shares, in sectors such as telecommunications, banks, infrastructure, REITs and healthcare.
These companies are often referred to as ‘quality growth’ companies, with stable or growing earnings perceived as having a greater certainty of being delivered. This has been ideal in the falling and low interest rate environment we are in, as these companies have been quite insulated from the economic cycle and many have maintained reasonable dividends.
This trend cannot continue indefinitely. These ‘quality growth’ shares have been heavily bought over the last few years which has pushed prices higher and they now trade on high earnings multiples. In our view there is little, if any, value remaining. As we are contrarian investors, for some time we have avoided these shares and instead have been looking to more depressed sectors of the market for value and better opportunities.
We often invest in shares that are widely disliked by the broking community as that is where we see the most value. We look at shares that other investors are discarding, with the belief that these companies will eventually return to favour – the antithesis to buying last year’s winners.
This is not as simple as it sounds. We can’t just buy any share that’s fallen and wait for it to rise. These shares are often marked down for a reason and there might not be a recovery. It’s our goal to find those companies with the potential to reverse their situations and outperform, which are viable businesses at their core.
Trying to invest in these turnaround companies can be like trying to catch a falling piano – very difficult and rarely is it successful without a fair degree of pain. Most people who see a piano plummeting from a tenth-floor window will run the other way; they don’t want to get flattened.
Likewise, investors are often afraid of buying shares when prices are falling sharply, as nobody knows exactly when these shares will hit the bottom. If they get it wrong the losses suffered hurt badly. But it should be remembered that the converse is also true and many investors have forgone opportunities.
We know that timing the bottom of the market is virtually impossible, so we need to accept that often shares will fall further before they recover.
This is exactly what is happening right now. The sectors which have been out-of-favour for the last few years have remained so and prices have continued to fall.
Our portfolio is currently invested in areas such as consumer discretionary, gold miners, energy and selective resources. Within each of these sectors we have found shares that are disliked by the wider market, which investors can buy for attractive prices if taking a long term view.
Let’s take resources as an example. Resources are well-covered in the news at the moment and the reporting is nearly always negative. Sinking commodity prices and stories of China’s demise have led to shares in this sector falling sharply.
Most investors run from bad news, but bad news excites us – that’s the time for us to start analysing a company. Resources shares are currently widely disliked by the broking community and in many cases, for very good reason. It’s most likely too early in the cycle to be rushing to buy some commodity producers, but the negativity that surrounds the entire sector has enabled us to find pockets of value which excite us, primarily in gold producers, oil and gas producers and aluminium manufacturers.
Investing in this style will not produce smooth returns (investors should be prepared for periods of underperformance, at times like those we have experienced recently), but there is potential for great outperformance. The cycle will turn and some of the companies that are suffering today will outperform tomorrow.
By focusing on investing in unpopular, undervalued companies, we can buy shares at meaningful discounts to their fundamental value with the aim of delivering superior long-term performance.
Simon Mawhinney holds a Bachelor of Business Science (First Class Honours) with majors in Finance and Business Strategy and a Postgraduate Diploma in Accounting (University of Cape Town). Simon qualified as a chartered accountant in 1998 and is a CFA Charterholder.