The Contrarian Manager Strategy - One Method of Outperforming Over the Long-Term

The contrarian manager strategy is composed of several key steps.  The first step is to decide what types of assets to purchase.  I tend to look at asset categories that have underperformed compared to others and that have experienced cash outflows.  These are prime areas to search for potential investments and as Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.”  Just because an asset class has underperformed does not mean that I will invest in it, but it does make it more likely that I will find an attractive investment.  While I think diversification is important, you also have to be wary of diworsification as well.  There is such a thing as too much diversification so I don’t feel like I have to own every asset class; I just want to own the most attractive ones and then weight them according to their attractiveness. 

The second contrarian decision is to purchase money managers that are truly contrarian managers.  Many portfolio managers claim to be contrarian, but a true contrarian manager will purchase assets when everyone else hates them.  They will buy unpopular stocks with depressed prices when everyone has “sell” or “hold” ratings and sell them when everyone loves them and all of the analysts have “buy” ratings. These are the types of managers that outperform.  Now going against the crowd is not always a wise decision as the crowd is sometimes right, so you good managers selectively go against the crowd.  But to outperform you have to do something different and be somewhat unique.

The third contrarian decision is to purchase the good contrarian managers after they have had poor performance.  A really good manager will bounce back and typically bounce back strong.  Good contrarian manager underperform for several reasons: sometimes their style is out-of-favor, sometimes they are too far ahead of other investors and it takes a while for the investor community to recognize the value of the assets they purchased, and sometimes they made a big mistake that hurt results but which they have learned from.  When these managers have bad performance and experience cash outflows I’m there to give them some cash inflows. 

Finally, the fourth contrarian step is to trim or sell the managers that have done extremely well since they have been purchased.  One of my rules is that if a manager I own becomes a 5-star Morningstar fund then I sell it.  5-stars means that everything has worked out well for that manager over the past 3 years, but that is very unlikely to continue to happen going forward.  I will also sell if a fund has had large cash inflows which usually happen after a period of very strong performance.  One issue with selling managers in a taxable account is that you create taxes, so to reduce this factor you can always reduce the turnover by the amount of trimming you do.  Also, instead of selling out of a manager completely, just trim. 

Now you may be asking how bad does a manager have to do and over what time period for it to be a candidate for purchase?  Also, how good does a manager have to do and over what time period for it to be a trim or sell candidate.  The short answer is, “it depends”, so let me give you an example.  Prior to 2011 the Fairholme fund (Ticker: FAIRX) had outperformed the S&P 500 in 10 of the previous 11 years. Bruce Berkowitz had definitely shown a contrarian streak and his performance had been excellent.  Performance had been so good that if you follow the contrarian manager strategy you wouldn’t have had an entry point.  That is until 2011 when the wheels came off and the fund lost 32% when the S&P 500 was up 2%.  That’s 34% of underperformance.  In this case while it was only over a 1-year period the amount of underperformance was so large that it would qualify as a potential purchase.  In 2012 Fairholme returned almost 36% compared to the S&P 500’s 16% return.  That is quite a bit of pain to avoid and a significant amount of outperformance to obtain by showing some discipline.  Now should you buy, sell, or hold since the fund performed by so much.  This is really quite subjective, but in my opinion rebalancing the allocation and maybe trimming the overall allocation is warranted since it outperformed by so much. However, I would not sell out entirely because you are talking about a good long-term contrarian manager that has a high likelihood of performing well in the years to come.  Although the contrarian strategy does create some turnover the ideas is still to hold these manager for long periods of time, so I wouldn’t sell out of a manager unless it’s performance was very strong over a multi-year period or off the charts over a short time period. 

Another fund that may qualify for use in the contrarian strategy is the First Eagle US Value fund (Ticker FEVIX). The current PM’s of the fund are relatively new, but the fund strategy isn’t and neither are the firms’ contrarian roots.  For three of the past four calendar years the fund has ranked in the 3^rd or 4^th quartile and YTD, as of 04/30/13, ranks in the bottom decile.  The one year they outperformed they were in the top decile.  In 2009 and 2010 they underperformed by modest amounts and in 2011 they outperformed by an ok margin but nothing extreme by any means.  However, over 2012 and YTD they have underperformed by over 11% cumulatively.  This has been an extended period of underperformance.  If you do believe they are good, contrarian managers then this may be a good time to purchase a moderate allocation as they have had an extended period of underperformance which I would argue increases the probability that they will outperform going forward.

Now this strategy is subjective and is not perfect as there is no such thing in the investment world.  But the idea behind it is to increase the probability of picking good assets, from good managers when they are most likely to outperform, and increase the chances of long-term outperformance.