Our New, Irregular Column on Contrary Thinking and Investing
Suppose you were to fall sick and visit a doctor, who prescribes a course of antibiotics. Suppose you are not happy with this doctor's diagnosis and wanting a second opinion, you visit another doctor who gives an identical diagnosis and prescribes the same medicine. Still not satisfied, assume you visit eight more doctors and all prescribe the same course of medicine. What should you do under these circumstances? The logical course for you will be to take the prescribed medicine. Doing anything else is likely to be foolish. If ten doctors agree on the proper medicine for you then you should take that medicine.
Investing is a Different Ballgame
Now lets change the circumstances. Suppose you were to visit ten investment counsellors, all of whom agree that you should buy a particular stock. What should you do under these circumstances? Here, the logical course for you will be to avoid that stock because if ten investment counsellors recommend that stock at the same time, its likely that its price is too high price because it already reflects the optimism of the professionals.
The above example, coined by the legendary investor, John Templeton, explains why achieving success in investing is quite different from achieving success in other activities. This is a vital point that many investors simply do not understand. Templeton's following words make it even more clear:
"It is crucial to understand, and very few people do, that attaining superior investment performance has nothing at all in common with succeeding in 99% of other occupations. If you were building bridges and a dozen consulting engineers experienced in bridge building all gave you the same advice, you'd be stupid not to build your bridge their way. In all probability, if the experts all agree, their way is the right way to do it. You'd build a better bridge at lower cost if you followed their advice. But the very nature of investment selection process turns that scenario topsy-turvy. Let's assume that every securities analyst you see says, "That's the stock to buy!" You might think that if all the experts are saying "buy," you should. But you couldn't be more wrong. To begin with, if they all want it, they'll all buy it and the price will build up enormously, probably to unrealistic levels. By the same token, if all the experts say, "It's not the stock to buy," they won't buy it and the price will go down. It's then, if your research and common sense tell you the stock does have potential, that you might pick up a bargain.
That's the very nature of the operation. It's quite simple; if everybody else is buying, you ought to be thinking of selling. But that type of thinking is so peculiar to this field that hardly anybody realises how valid it is. They say: "I know you're supposed to look where other people aren't looking," but very few people actually understand what that means."
Principle of Maximum Pessimism
On another occasion, Templeton said: "In almost every activity of normal life people try to go where the outlook is the best. You look for a job in an industry with a good future, or build a factory where the prospects are best. But my contention is if you're selecting publicly traded investments, you have to do the opposite. You're trying to buy a share at the lowest possible price in relation to what the company is worth. And there is only one reason a share goes to a bargain price: Because other people are selling. There is no other reason. And to get a bargain price, you've got to look for where the public is most frightened and pessimistic... People are always asking me where is the outlook good, but that's the wrong question. The right question is: Where is the outlook the most miserable?"
Templeton calls this the "principle of maximum pessimism". Others call it contrary investing. It is simple common sense that to produce a superior performance one has to do things different from the majority. That is exactly what contrarian investors do. They try to take the view that is opposite to the view prevalent in the marketplace. There are huge profits to be made by adopting a contrary approach, provided the contrarian turns out to be right more times than wrong.
Easy to Preach, Difficult to Practise
I couldn't agree more with Templeton when he says that very few people actually understand what contrary investing is all about. While many investors recognise the need to be different from others, when it comes to specific situations, they panic and run for safety in a crowd. As a result, there are far fewer practitioners of contrary investing than the number who claim adherence to the faith.
For example, typical investment counsellors are advising investing in Indian bonds instead of Indian stocks and even if stocks are being recommended, they usually come from either the automobile sector or the hotel sector, both currently booming sectors having already experienced significant amount of price appreciation in the last two years. On the other hand, how many people, including yourself, do you think would be looking for possible investment opportunities in bombed-out sectors such as non-banking financial companies, or companies allegedly involved in fraudulent activities or companies that have defaulted on their debt obligations or even companies that have been declared sick? Not many. But Templeton's principle of maximum pessimism requires one to look in exactly these type of situations.
Most people fail to realise that under certain circumstances, there is a lot of money to be made by buying stocks of companies that most people think are going to fail, or by buying stocks of companies whose managements are known to be dishonest, or buying stocks of companies that are experiencing difficulties such as making losses, having weak balance sheets, or being involved in frauds, natural disasters, or specific industry downturns.
Templeton's Coup in Peru
Most investors are simply not temperamentally equipped to buy into a contrary situation such as investing in a country when the mobs are in the streets or the currency is collapsing amid runway inflation. But Templeton had no such temperamental problems when he considered investing in Peru under similar circumstances in 1985. At that time, the country, according to Templeton, was a mess. Those Marxists/Maoists, the Shining path, held the country in terror. Money and middle-class people were fleeing the country. But this very fact attracted Templeton to Peru. He knew his history and remembered that in 1930s this natural-resource rich country had an active stock-market - bigger, in fact, than Japan's at the time. But by 1985 the combined value of all Peruvian stocks came to less than $400 million, about the capitalisation of one midsize U.S. biotech stock. "That was for me a point of maximum pessimism," says Templeton.
He invested in Peru when Lima's Bolsa de Valores index, in U.S. dollar terms, was at around 50. By 1995, the same index was quoting at 6800. You can imagine yourself the amount of money Templeton would have made by taking the contrary decision of investing in Peru. "Peru is a good illustration that when you're buying publicly traded investments, you have to do the opposite of what you do in all other aspects of life," says Templeton. "That's why successful investing is so difficult... To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest reward."
Another Example
Here is another example of what contrary thinking is about. Suppose you were given these two choices and you had choose one. Choice A: Stocks go up quite a lot - and stay up for many years. Choice B: Stocks go down quite a lot - and stay down for many years. Without looking below, which one did you choose?
If you selected choice A, you would be joining 90 percent of the professional investors who have taken this little test. But, I think you will think again when you read these words spoken by another legendary contrarian investor, Warren Buffett, on the occasion of an annual meeting of his company, Berkshire Hathaway:
"The best thing that could happen from our standpoint is to have markets go down a tremendous amount. If you asked us next month whether we'd be better off if the stock market were down 50% or if it remained where it is now, we'd tell you that we'd be better off if it were down 50%. We're going to be buyers of things over time. If we're going to be buyers of groceries over time, we'd like grocery prices to go down. If we're going to be buying cars over time we'd like car prices to go down. We buy businesses. We buy parts of businesses called shares. And we're going to be much better off if we can buy those things at attractive prices than if we can't. We don't have anything to fear. What we fear is a long, sustained, irrational bull market."
I have yet to meet a person who behaves in the contrary fashion that Buffett prescribes above. But it is the only logical way to behave. Remember, that when you buy an equity share, what you really buy is the right to share in future earnings of the company. Just as we buy cows for their milk and hens for their eggs, we buy stocks for sharing in their future earnings. If you owned a dairy, wouldn't you prefer to have cow prices low when you were buying, so that you could get more litres of milk for your investment in cows?
Relative to their value, the lower the price of the shares you buy, the more the shares you will get for every Rs1,000 you invest and the greater will be the returns (as dividend and capital gains) on your investment. So if you are a saver and a buyer of shares - as most investors are and will continue to be for many years - you real long-term interest is to have stock prices go down quite a lot and stay there, so you can accumulate more shares at lower prices and thereby receive more returns with the savings you invest.
The above example again illustrates how important and yet, how difficult it is for most people to think and behave differently from the majority. Most investors illogically become euphoric when stock prices rise and unhappy when they fall. They display no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. It's the seller of food who dislikes declining prices. Identical reasoning should guide investors' thinking about investments. If an investor will be investing year in, year out, then declining prices for businesses would benefit him, and rising prices will hurt him.
That's contrarian thinking and investing from Warren Buffett. Articles that appear in this column in the near future will develop ideas on contrary thinking and investing, particularly in the Indian context. Watch this space.
Profitable Contrary Behaviour - A Poem By Robert Frost
The Road Not Taken
Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveller, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;
Then took the other, as just as far
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,
And both that morning equally lay
In leaves no step had trodden black
Oh I kept the first for another day!
Yet knowing how way leads on to way
I doubted if I should ever come back.
I shall be telling this with a sigh
Some ages and ages hence;
Two roads converged in a wood, and I -
I took the one less travelled by,
And that has made all the difference.
Note
This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited.
© Sanjay Bakshi. 1996.