Contrarian Investing in Bite-Size Pieces: Part 2

Published in Investing on 13 November 2012

Owain Bennallack chats with Alastair Mundy, head of the Contrarian team at Investec Asset Management.

This is the second part of a two-part transcript in which Owain Bennallack chats with Alastair Mundy, head of the Contrarian team at Investec Asset Management.

Everyone claims to be a contrarian investor, so at least half of them must be wrong -- contrarian investing should be as unfashionable as shoulder pads and Hawaiian shirts. In fact, according to Alastair Mundy, genuine contrarianism should leave you feeling sick to the stomach at the fear of betting against the crowd. Discover why he's a contrarian investor, how some of his investments worked out -- and exactly why he doesn't want to fight Lennox Lewis, in this episode of Money Talk with Owain Bennallack.

You can read the first part of the transcript here.

You can listen to or download the full podcast here.

Owain:

OK, well, I think this would be a good opportunity for us now to move into a few more specific companies. You say in your book actually, and you've already alluded to it, that you like to go into pubs, looking for old ladies to beat up on, and a naive contrarian investor looks for Lennox Lewises. So I'm assuming that the stocks that I'm going to mention, that I think you're kind of holding at the moment, or you vaguely like, are more kind of, an old lady can, and you look a bit scared. You think you've met your Lennox Lewis already, Alastair. I'm going to quiz you first of all about your shares in various building material firms: Travis Perkins (LSE: TPK), the Grafton Group (LSE: GFTU) – Alastair, what are you thinking? Are you nuts?

Alastair:

Yes.

Owain:

Everyone knows there's a property slump going on. Look outside the window, read the news – what's going on there?

Alastair:

Yes, I can understand why everyone would think it's a crazy investment to make. The interesting thing for us is, most people who we mention, Travis Perkins or Grafton, agree that they're good companies. These are companies, builders' merchants. They've got strong local monopolies, i.e. if a builder's doing some work round your house, and dashes off for a piece of timber, he just wants to go to the local builders' merchants – he's not going to drive around for hours, because it's his time he's wasting. But he's wasting your money, that's the great thing, so he doesn't really care what price he pays, especially if he can negotiate a discount on the side. So we think these companies have got very strong characteristics, but they are struggling at the moment – you're right, there is a building slump. People haven't been spending a lot of money on repair and maintenance, and therefore these companies are still nowhere near what we regard as their peak profitability. We think they can do better, but yes, that better only happened in three or four years' time. We get the opportunity of what we call time arbitrage – investors are unwilling to wait three or four years. They think they can time their entry into these shares much better than we can, and not waste dead money for two or three years. We think, if we can find a cheap share, if it's going to take three, four or five years to prove it was cheap, we think that's worthy of an investment. So we're always looking at recovered profitability, i.e. not what the company's making in profits today – what it can make when it's more normal conditions.

Owain:

Did they do rights issues, those companies? Because something I've found with some of these construction firms is, you look at them, and you look at the revenues they used to have, and the profits they used to have, and then you think, OK – they're getting back to that, and then you look at the share count, and you think, oh, OK – well, there's now a squintillion more shares.

Alastair:

Yes, obviously you always have to allow for that, you're right. Many companies in 2008/09 did have to have rights issues, so yes, you've got to be aware of how many shares are now in issue.

Owain:

And do you take a view on like the property market in general, when making an investment like that? Or are you kind of like, economically agnostic?

Alastair:

A bit of both, if that's possible ... well, economically agnostic in that we don't make forecasts for what the economy's going to look like in three, six, nine months' time. However, we might say, what are the level of housing transactions now relative to the last 20 years, or how much money is being spent on refurbishment and repairs, relative to the last 20 years. So we're typically saying, if those are really depressed at the moment, we'd expect them to improve over the medium term.

Owain:

So you sort of believe in the revision to the mean?

Alastair:

That's right, yeah. But it's important, not everything reverts to the mean. Accrington Stanley are unlikely to ever win the Premiership, so be careful.

Owain:

They had their moment in that advert, didn't they?

Alastair:

That's right.

Owain:

Now, in your book, you say a proper contrarian investor should feel like someone alone in a restaurant, feeling out of place, stared at and uncomfortable – something I find quite easy to imagine!

Alastair:

So do I!

Owain:

Imagine you're in that restaurant now then, Alastair. There's a hen party to your left, there's a young couple kissing enthusiastically to your right. The year is 2008, and you, in your wisdom, have decided that you're going to go and buy shares in the jewellery firm Signet (LSE: SIG).Why would you have bought that company then?

Alastair:

That's right – I was thinking something similar at the time. I think you spotted a book, from my comments on sitting in a restaurant are quite autobiographical as well. Yes, Signet – obviously a jewellery company, sells jewellery in the UK under the H Samuel name, and in the US under a variety of brands. We bought it originally because we thought it had a very strong position, particularly in the US jewellery market, and we thought it was going to continue to strengthen that position.

Owain:

But I mean, at that point in 2008, that was sort of, the financial world was coming apart. People were sort of saying, go and buy baked beans.

Alastair:

That's right. The US consumer was already struggling very significantly. But what we liked was the fact that, forget the demand side, the demand for jewellery – we were attracted to the supply side, i.e. the number of jewellers that were going out of business was extraordinary, and I think out of the 10 jewellers, the top 10 jewellers in the US selling speciality retail, i.e. ignore the Wal-Marts of the world, I think seven of the top 10 ran into some sort of financial difficulties. Two were run by Buffett, which didn't run into difficulties, but he never much gave capital to expand, and the other one was Signet. So we always believed Signet would almost have a good recession. It would come out much stronger relative to its competitors than it did. We didn't really envisage quite how much pain we'd have to go through first, to try and be proved right, but fortunately we're still standing after that experience.

Owain:

Yeah, that's really interesting, because so often you see a company that reports bad results, and then a company in the same sector, but because there's some sort of read across, it's presumed – I mean presumably you think that, in the short term, maybe that's true, but over the long term, the winning companies that can build on the failings of their competitors.

Alastair:

It's an interesting point. With Cygnet, its main competitor for years has been Zales (NYSE: ZLC.US), and Zales has been through more chief executives than Aston Villa have been through managers. But it was lovely competition for Signet to have, and that was, I think, part of the secret of their success.

Owain:

You still hold the shares now?

Alastair:

That's right, we do.

Owain:

So it's now four or five years – why do you still hold them, what's the thinking there?

Alastair:

Well, they're still in this position where the other retailers are very poor, really struggling, and they continue to strengthen their position. When you're the largest player, you've got advances in advertising, in getting good locations for your stores, in getting exclusive brands, so we think that being big is going to benefit them even more than it has done in the past.

Owain:

So obviously then, you're quite happy to hold these shares for years on end. How do time when you sell them? Do you look at the valuation, or would you look at that? All the competitors have gone, and everyone's buying two rings instead of one – do you think it's about as good as it's going to get?

Alastair:

That's right – we never do timing, so if it takes a stock a week to get to our fair value, we'll sell it; if it takes it 10 years, that's fine, and we never time a stock out. We'll never sell a stock through boredom. We'll only really sell a stock if it hits our assessment of fair value. Now, there's obviously two ways: by the stock going up to reach a value, or the fair value falling, and our share price falling as well. We just have to keep going back to what level of profits do we think this company can make, and what will other investors pay for that level of profits in normal times. We multiply one by the other, and that's our fair value, and it typically takes five years.

Owain:

Do you have a problem ever with, you have other competing candidates, and you have to decide which one's the cheaper? Or do you sort of stick to your horses?

Alastair:

Yes, it would be lovely to say we've always got competitive tension on the portfolio. We've got so many great ideas waiting to get on, that there's always competition for places, like a good football team. Unfortunately, it's not that easy, and we typically, on a portfolio, have 10-15% cash. It's quite interesting, once again in the book, I think I refer to it that the academics have spotted in America, fund managers are very good at finding five or 10 really good ideas. What we're not very good at is filling up our portfolio with lots of other ideas, to make sure we've got 100% portfolio invested, so the stocking fillers, just like all of us buying for our other halves perhaps, when we're desperately looking for something to buy on 24 December, we don't cover ourselves in glory.

Owain:

Are you saying a Terry's orange has no place in your portfolio?

Alastair:

That's right, yeah – or at home, with Mrs Mundy. So I think, what we try and say is, keep our valuation discipline. If we can't find anything worthy of being put in the portfolio, we'd be happy to hold cash, and wait for something cheap to come up.

Owain:

OK, and what happens when you have two kind of contrarian investing ideas that conflict? I'm thinking of your chapter on IPOs, which I read – I might get extra marks for that, I hope. Like most value investors, you don't like IPOs, but did you like the recent Direct Line (LSE: DLG) float, which was from an unpopular bank, RBS (LSE: RBS). It was insurance, which even before all of the flooding in the US, was an unpopular sector at the moment – too high yields, low P/Es. Were you sort of torn asunder by that?

Alastair:

Yes. The reason we don't tip it like IPOs, and I think in the book I refer to Ocado (LSE: OCDO), was they're typically puffed up by the investment banks, who tell you what a great story it is. The sellers are selling, because they want to raise some cash, and lock in their own profits. They give you a great story, which turns out not to be quite so great, once you're invested. Therefore, the odds are against you – typically, the seller's selling for a reason. With Direct Line, the reason Royal Bank was selling was because they'd been forced to sell by the EU, so they're a forced seller, which is very attractive, and we like the fact that Direct Line used to be a very entrepreneurial company. I remember, when I first started investing twenty-odd years ago, Direct Line was leading edge. It had that little red telephone, and the great idea is, you rang them for insurance quotes – an extraordinary idea at the time, and they were really ahead of the pack. I think, having been fully-owned by a bank for many years, particularly a bank not doing very well, they probably haven't had much tender, loving care, and have lost their way, and we think you're absolutely right. It's an industry that's not doing very well, and a company within that industry who's not doing very well. Our guess is, there's lots of costs to be taken out. Perhaps the management will now see more potential to make money out of share options, and therefore sort of find some better ideas to really drive profitability. So yes, we often contradict ourselves, and that's one of the great things about investment – you can't just use one or two formulas which will always work. You've always got opposing ideas racing round in your mind.

Owain:

Yeah, absolutely. So I was going to ask you a bit about banks, but we sort of touched on the banks, and the dark, or bright, days of 2007, depending on which side you're on, I suppose. Can you suggest any other shares or sectors that our listeners might want to cast their eyes over at the moment?

Alastair:

Yes, in general, the sort of companies we're looking at at the moment are those which are affected most by the economic cycle. I think in general, investors, profession or private investors, have been buffeted around so much for the last four or five years, they want certainty, and there's a certain sort of company that they think they can find that certainty from, companies that are typically called defensives, where they've got strong brands, perhaps exposed to emerging markets, and typically generate a lot of cash, which, who wouldn't want to invest in those stocks? Unfortunately, typically you have to pay quite a high price, whereas the stocks that people are less willing to invest in are those where you're really betting on the future looking a lot better than it is today, and we spoke about some of them, with Grafton and Travis Perkins. But typically, across the world, those stocks most exposed to the economic cycle, and it might be, whether if it's in hotels, or retailing, or building, we think are the most attractive sectors for the long term now, because there's so much money moving towards safe yielding stocks.

Owain:

It's true, every fund manager I see on TV sort of says that he's putting his money into safe, dividend-paying, consumer-focused defensives. You can see it in the valuation, companies like Diageo (LSE: DGE).

Alastair:

There used to be an expression, when I started work – you'll never get sacked for buying ICI; now it's, you'll never get sacked for buying Diageo.

Owain:

Whereas probably ICI would be considered a risky ....

Alastair:

Yeah, you should have been sacked for buying ICI all those years ago.

Owain:

I mean, I guess, that doesn't mean necessarily that you have a view on the economy. You don't necessarily think next year things are going to get better or worse, you just think, at some point things are going to get better.

Alastair:

Yes, and I think what people always tend to forget, when they are making these grand economic forecasts, it doesn't matter really. What matters is what's in the price. If there's already a very deep recession baked into a shares valuation, things only have to be a little bit better than that very deep recession for an investor to make money. It's not a competition on working out what GDP growth is going to be – there are no prizes for that, whatsoever.

Owain:

That's good, because I'll never win that competition, and nor will anyone else!

Alastair:

That's right, especially the people who put the data together.

Owain:

Yeah, exactly. OK, well that's been a very interesting romp through the upside-down world of contrarian investing, and on that note, we like to end every podcast with a quote, and I found one that seems suitable for exactly that reason. It's from Charlie Munger, who I think you might mention in your book.

Alastair:

I do, I give him a good mention.

Owain:

Yeah, Warren Buffett's sidekick, and he cites the 19th Century mathematician, Carl Jacobi, who said that, "When you're trying to get to the heart of a tough problem, always invert." In investing terms, I guess that might mean that, if you like a company, there's still reasons why you shouldn't, and if you think a company's going to go bust, find all the reasons why it won't, and then at the end of it, see if you've sort of changed your mind. Indubitably, you do challenge your own hypothesis.

Alastair:

That's right, yes. I've always thought being schizophrenic is the right way to look at stocks. You always question yourself.

Owain:

OK, well, obviously everyone out there now is desperate to hear more from Alastair, but we're about to finish the podcast. However, we have got a chance for you to win a copy of Alastair's book, You Say Tomayto, or "Tomato", as I would say, but that's the nature of the book, clearly. All you have to do, to be in with a chance of winning Alastair's book, is to answer the following incredibly easy question, which is, which investor said you should try to be "fearful when others are greedy, and try to be greedy when others are fearful"? Alastair's about to give the answer, but he's been shushed. So, if you know the answer to that question, please email moneytalk@fool.co.uk. You have a week to answer, and when we've got a winner, we'll get in touch with you, if you've won; obviously we won't, if you've not won, but we will announce who's won the book on this podcast page. OK, so that wraps up the podcast. Thanks Alastair, for coming in today, and for giving us so much to think about, and I hope you keep all your fingers in the future.

Alastair:

Thanks, Owain.

Owain:

Cheers!

That was the second part of a two-part transcript in which Owain Bennallack chats with Alastair Mundy, head of the Contrarian team at Investec Asset Management.

In the first part of the transcript, discover why Alastair is a contrarian investor. Just click here to continue reading.

If you're keen to earn even greater returns, this free Motley Fool report -- "10 Steps To Making A Million In The Market" -- could help you on your way. The report highlights how choppy markets can still provide the big winners to take you to that magic million. But hurry, the report is available for a limited time only.

Share & subscribe

Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

XMFSonia 16 Nov 2012 , 3:14pm

Hey Fools

The podcast competition to win a signed copy of Alastair's book is closing on Sunday.

Please email your answers to moneytalk@fool.co.uk , and don't forget to supply a postal address.

Good luck!
Sonia

XMFSonia 19 Nov 2012 , 11:45am

Hi Fools

Thank you to everyone who entered the competition.

The answer to the quiz question is Warren Buffett, and the winner is Sam Scott from Devon. Congratulations Sam!

A copy of the book is in the post and should be with you shortly.

Enjoy the read!
Sonia

Join the conversation

Please take note - some tags have changed.

Line breaks are converted automatically.

You may use the following tags in your post: [b]bolded text[/b], [i]italicised text[/i]. All other tags will be removed from your post.

If you want to add a link, please ensure you type it as http://www.fool.co.uk as opposed to www.fool.co.uk.

Hello stranger

To add your own comment, please login.

Not yet registered? Register now.