Effective Contrarianism

The fine line between being calculated and extreme

Photo by Nick Fewings on Unsplash

All good investing, in my humble opinion, embraces nuance. If you are too dogmatic and only engage in black or white thinking, the market is likely to humble you, at least over the long run. Success in investing is often derived from picking up on nuances: the inflection point in a company’s operations or the little business the company is investing in aggressively that no one is paying attention to, yet. And failure can becomes much more probable if all you are looking for is silver bullets. Investing—as is life in general—is messy and doesn’t lend itself to sweeping generalizations and broad characterizations. Sure, there are some timeless philosophies and processes but more often than not, the answer to most investing-related questions is, “it depends.” It depends on management, valuation, the macroeconomic environment, competitive dynamics, and the vicissitudes of end markets. Nothing always works and very few things never work.

Being a contrarian, which many in the value community self-identify as, also requires a nuanced perspective. I might even argue that being a contrarian in the right circumstances—as opposed to using contrarianism as a blunt instrument—is an art form. What got me thinking about all of this is a conversation, I had with my friend, Toby Carlisle, who manages a couple of ETFs with the catchy tickers DEEP and ZIG. We recorded a fun podcast that is going to come out in a few weeks. But at the end of the podcast, when we were discussing why he owns oil & gas and coal stocks in his concentrated Acquirers ETF (the aforementioned ZIG), he said something that struck me. Toby mentioned that he is willing to go against the prevailing negative narratives surrounding coal specifically and then made an articulate case for why, especially metallurgical coal, might experience even greater demand as the world transitions to greener forms of energy. In other words, he is willing to be a contrarian in the right circumstances. In my next questions after that, I insinuated that Toby proactively looks to swim against the tide and he quickly corrected me. There is a big difference between willingness to be a contrarian and looking for opportunities to be a contrarian. It might seem like an insignificant nuance but I see it as more profound.

It goes without saying that there is money—and big money at that—to be made by successfully betting against a trend or market environment that is about to reverse. Just think back to March of 2020 and the returns that could have been generated by anticipating that vaccines would be available rather quickly—and that the world would open up far earlier than many people feared. In hindsight, people who saw that period as a once-in-a-generation buying opportunity for great businesses were quickly proven right. When many professional investors, even seasoned ones, were worried about prolonged lockdowns, widespread business bankruptcies and struggling consumers, it paid to be a contrarian. That was true whether you were actively looking for a reason to be a contrarian or you thought the odds were so much in your favor that this was the time to be willing to take the other side. Nuance didn’t really matter in this case. Being a contrarian worked regardless.

A lot of value investing is predicated on a persistent willingness to do the opposite of what the crowd is doing. What is deep value investing, which Toby is an unabashed devotee of, other than searching for stocks that are deeply out of favor and buying them when they are dirt cheap? The worst, price-taking, secularly declining business in the world can be a good investment at the right valuation. Even compounder bros like myself put money to work in business for which our contrarian/variant perception is that the market is underappreciating the rate a company can compound its capital. To beat the market, you have to hold a different view of the future than the market has, whether your goal is to hold a stock for ten years or three months. All good investing also requires a contrarian streak that complements the aforementioned appreciation for nuance. However, it can’t be true that it pays to be a contrarian in every situation. Markets, despite having their manias and depressions, are generally efficient over the long run.

Sounds like an impossible equation to solve. You have to simultaneously be willing to take a contrarian perspective and actively avoid doing so the majority of the time. (Have I ever mentioned that being a good investor is hard?) What I am proposing is that there is a distinction between extreme “me against the world” contrarianism—where people embrace a 180 degree, polar opposite view from what market is telling them—with a less binary perspective that is only 15 degrees off (let’s call this calculated contrarianism), but which can be lead to meaningful deviation in performance over time. These two are quite different even though it may feel as though you are flexing the same muscle. And it is that nuance I believe the best risk takers embrace.

Put away the hammer

Most readers will be quite familiar with the old adage about everything looking like a nail to the man with a hammer. It serves as a cautionary tale that suggests we approach the world with more nuance. It takes perspective to realize that not everything is a nail that needs to he hammered down. Applying this metaphor to the investing realm, the risk that all investors face is using contrarianism as a hammer. The person actively looking for opportunities to embrace the other side of every argument, consistently debunk prevailing wisdom, or who simply wants to love any hated company or industry, would seem to me to ignoring probabilities and base rates. I don’t have any data on how often the market is “wrong” about a given stock. I am not even sure how you would track or test that. But if you believe that markets get it sort of right, most of the time, it is hard to imagine the hit rate of being a contrarian for contrarian’s sake is particularly high.

I know people who enjoy arguing that the sky is red if you believe the sky is blue. It is in their nature to swim against the popular tide, regardless of topic or level of expertise. That trait has probably helped them, at times, during their investing careers. For instance, if your inclination has been to buy every single dip in the market since, I don’t know, March of 2009, you have largely been right in implementing that strategy. There is a certain amount of inevitable pattern recognition that is developed after years operating in financial markets. In recent times, many investors have “learned” that putting on risk anytime the market has a hiccup has an extremely high hit rate.

I know, I know. Markets go up over time. Time in the market is more important than timing the market. I don’t disagree with the idea drawdowns are often opportunities to buy great businesses at more reasonable valuations. I just think that the ZIRP period birthed a lot Nassim Taleb’s famous Thanksgiving turkeys. Every day of the turkey’s life the farmer is the turkey’s friend. She feeds him. She talks to him. Sorry if this is a bit morbid but it is the truth that all of the positive reinforcement ends quite abruptly shortly before Thanksgiving—seemingly without warning from the turkey’s perspective. Similarly, zero percent interest rates, easy credit, covenant-lite loans and massive fiscal stimulus covered up a lot of sins and allowed business to be financed and supported that likely were not viable otherwise. It felt like the market was your friend (it basically went up) and it didn’t take much nuance to be a successful contrarian. But my sense is that what eventually happens to investors who aren’t very thoughtful and strategic about when they are willing to pull out their “the world is totally wrong and I am right card” is that their view of an accommodating market changes just as quickly as the turkey’s perception of the farmer.

Assuming that is accurate, how can we, without the benefit of hindsight, know when it makes sense to bet that consensus is dead wrong?

When to swim against the tide

I wrote a long piece on complexity a few weeks ago where I made the point that there aren’t any extra style points awarded for stepping into complex investing situations. In my experience, there is a high degree of overlap between people who are the more extreme contrarians and the willingness to invest in very complex, messy securities. My premise is that just because everyone is running away from a stock because the company is the financial embodiment of a burning building, doesn’t mean you should look for reasons to run into the building. It might legitimately be about to collapse. Complexity breeds both opportunity and spectacular failure, the latter being particularly likely if you have yet to develop a proper contrarian situation assessment toolkit. (More on this below.) When it comes to complexity, it seems reasonable to adopt Toby’s perspective and be willing to look at complex things but not seek to get involved when there is a high degree of difficulty.

Where I am going with all of this is to try to figure out when it makes sense to make a wager, in whatever size, that consensus is totally wrong—the more extreme form of being a contrarian. In public equities, I am willing to assume that it basically always makes sense to try to develop an informational edge and employ calculated contrarianism. That is the basis for the compounder style of investing and getting rich slowly. On the other hand, the quintessential example of extreme contrarianism is the bet that John Paulson (among others of course) made against subprime mortgages. Everyone “knew” that AAA-rated MBS were money good. It took a band of devout contrarians and sort of misfits to figure out—and then point out—that the housing securitization emperor had no clothes. That is tough to do, especially when so many people are telling you that you are wrong. Only the most stubborn people refuse to give up in a scenario like that. I would argue there is a fine line between being perceived as stubborn and outright crazy—and the way events actually play out determine if the contrarian looks heroic or foolish. No one makes any money on counterfactuals in the investment business.

As I think through the examples of fortunes that were made betting that a major trend would reverse, that a darling investment was fundamentally flawed, or that a security was completely underappreciated by the market, there appear to be a handful of common elements, some of which may be partially overlapping:

• A valuation that is massively divorced from the true fundamentals, either positively or negatively.

• Consensus that is highly skewed in one direction, with little tolerance for opposing opinions to be expressed.

• Substantial asymmetry in the form of a small bet or position size paying off in multiples.

• A trend that has lasted for a long time or a stock that has been successful (or unsuccessful) for years and has allowed market participants’ views to become stale, calcified or undifferentiated. In other words, some inertia has set in.

• A degree of false certainty that comes from the lack of regulatory action or the stock market not punishing bad behavior. (Think Enron or Wirecard in this case).

• Being near an inflection point that reveals the truth, either good or bad. Being early is typically indistinguishable from being wrong, especially if you are an investor who is dependent on the kindness of strangers or outside investors for capital.

• A willingness to look wrong—potentially for years—but to continue to perform diligence in order to bolster an investment case.

• Having a stable, understanding, and patient capital base that allows an investor to have a trade on, even if it doesn’t work for a while.

I may be missing some items but I think this makes the point that, while it is possible to make generational wealth in standing firmly against the crowd, so many elements need to be place for that to happen that the probability of success would seem to be pretty low. We know the stories of people who made a lot of money—they are essentially the survivors. We never hear about the people who embraced extreme contrarianism and were proven to be early, wrong, or tilting at windmills. I guess it all comes down to expected value. Betting on low probability events that offer a high payout and inflict minimal damage if they don’t play out—and may even serve as an effective hedge against something else in the portfolio—is a viable, maybe even value-additive strategy. Make a bunch of little bets, assuming you will be wrong on almost all of them, and hope that one is a homerun. That, to me, is where “me against the world” contrarianism has a place. Otherwise, reflexive contrarianism that stems from a joy of being different seems to represent the overuse of what is otherwise an important muscle.

Scratching the contrarian itch

I am admittedly someone who has an urge to bet against a pendulum that has swung way too far in one direction. As a I wrote back in 2021, I felt it in my bones that certain beloved stocks and asset classes would eventually fall back down to earth. It happened; probably because a number of the above bullet points were checked off. My timing was lucky in that case, but I am sure that my extreme contrarian Spidey-sense has been wrong many times before. I honestly haven’t been keeping track because my days are spent trying to practice more calculated contrarianism. Plus, I don’t always feel that strongly about what I see as the consensus view. Right now? While I have no skin in the game associated with any of the following items, just for fun, here are some things I see that are sounding my internal “this doesn’t make sense” alarm bells:

• I think it is highly unlikely that Ozempic and the other weight loss drugs are going to negatively impact as many industries as is being anticipated at the moment. I sincerely hope that these are miracle drugs that cure addiction, over-consumption of highly processed foods, obesity and diabetes. That would be a wonderful outcome for society and people who are struggling. It just seems far too early to tell what the ultimate society-level impact will be or if businesses that seemingly had huge moats, great brands, and secular tailwinds are truly at risk of disruption.

• Going the other way, when I look at what is going on with AI right now, I start to think that people are underappreciating how many industries are going to be impacted by this technology. I have no views on what have become the obvious AI trades, such as NVIDIA. I just wonder if AI is going to impact certain business models like the internet decimated newspapers and the Yellow Pages. It might be early but it feels like we are on the verge of a paradigm shift or regime change that fundamentally alters our daily routines and impacts financial markets.

• I was at the LD Micro investment conference last week in L.A. I am not sure I have ever seen a more despondent group of execs in my career. Being a microcap company—and CEO—right now is not a lot of fun. Many people see no reason to be public anymore, given the lack of interest in their companies. On the other end of the spectrum, seven megacap companies are driving the S&P 500 higher. The spread between the love for large companies and the disdain for small companies has become really, really wide. I am sure a lot of that is justified based on business model differences but that doesn’t mean the pendulum hasn’t swung way too far in the direction of the behemoths. I met with a handful of real companies that seem to be performing well, yet their stocks drift lower, seemingly without explanation. Maybe we are headed towards a rough patch in the US economy that uniquely impacts small companies that have limited revenue diversification. But at a certain point, select companies with good balance sheets and that have a reason to exist will trade at valuations that offer too-hard-to-pass-up risk-adjusted IRRs.

Is there any chance I will proactively put money to work based on any of the above contrarian stances? Regarding the first two, it is unlikely. I will, however, be forced to consider them both as risk factors for any companies I am looking at and consider dipping my toe into businesses that look like they are being more than unfairly punished. What about the third one? I have some ideas on how to combine extreme contrarianism with the more calculated version in microcap land, a universe I basically wrote off in the not-so-distant past. It feels like a unique time to take a swing. (Checks the list of bullet points above: looks like 4 out of 8 are satisfied. It is the last 3 that are the hard ones, though.) All I can say is, stay tuned!

Taking a contrarian stance against my own prior stated views,

Ben Claremon