Discovering Value


How Contrarians Win

In his classic book The Money Masters, John Train recounts how just after the start of World War II, a young John Templeton placed an order to buy $100 worth of every stock that traded on a U.S. exchange for $1 per share or less. After the broker reported that he’d bought every such stock except those of companies in bankruptcy, Templeton replied: “I want them all. Every last one, bankrupt or not.”

Once all the orders were executed, Templeton owned shares in what Train calls a junk pile of 104 companies (34 of them in bankruptcy) for a total of about $10,000. Convinced that war would pull the U.S. out of the Great Depression, Templeton had bought the market’s most neglected shares, betting that they would gain the most. After holding the stocks for an average of four years, Templeton eventually sold all of them for more than $40,000, cementing his status as a classic contrarian investor. His oft-repeated quote on the subject: “It is impossible to produce superior performance unless you do something different from the majority.”

Key to success. Value investors are contrarians at heart, buying what’s out of favor and selling that which the market loves. But taking a contrarian view doesn’t by itself guarantee profits. After all, the market is usually right. To succeed as a contrarian, you must recognize what the crowd believes, have concrete justification for why the majority is wrong, and have the patience and conviction to stick with what is, by definition, an unpopular bet.

Because of the market’s spectacular rally since March, it has become much harder to find unloved, bargain-priced stocks. Based on average inflation-adjusted profits over the past ten years, Standard & Poor’s 500-stock index traded in September at about 19 times earnings. The market’s average price-earnings ratio over the past 130 years is 16.3. So although stocks are not in bubble territory, they’re not cheap, either.

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In general, the stocks of the most speculative companies have climbed the most, on the belief that the economy is poised to recover sharply. We’re skeptical, so we have been positioning our portfolios more conservatively by adding to our short positions, lightening up on stocks that have run up strongly and moving more money into brand-name companies, which have lagged during the rally.

Investors fear that health-care reform will hurt the entire industry, a key reason that the sector trades at just 12 times earnings, or 36% below the P/E of the S&P 500 (historically, such high-quality businesses have commanded higher P/Es than the index). We think that the pessimism is overdone.

One way to play the sector is through Pfizer (symbol PFE), the world’s largest drug company. It holds $10 billion in cash (net of debt), and at an early-October price of $17, it trades at 8.5 times expected 2009 earnings of $1.97 per share. That’s far too low for a company of its caliber. While waiting for the market to recognize the value we see, investors will earn a dividend yield of nearly 4%.

Facing strong competition from Google and having botched its proposed acquisition by Microsoft, Yahoo (YHOO) is also out of favor. By 2011, we expect Yahoo to generate annual earnings before interest, taxes, depreciation and amortization of $2 billion. To that figure, we apply a multiple of ten because Yahoo has a business model that requires relatively little capital. Add another $16 billion for the value of Yahoo’s cash and its stakes in Yahoo Japan and China’s Alibaba Group, and we figure the stock can appreciate at least 50% from its early-October price of $18.

Going against conventional wisdom isn’t easy. Leave it to Berkshire Hathaway’s vice-chairman, Charlie Munger, to offer a simple and powerful rule of thumb for doing so: “Learn how to ignore the examples from others when they are wrong, because few skills are more worth having.”

Columnists Whitney Tilson and John Heins co-edit Value Investor Insight and SuperInvestor Insight. Funds co-managed by Tilson own shares in Pfizer and Yahoo.


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