How Pros Judge When to Stray From the Herd

Coulda, shoulda, woulda.

As the 1990s stock bull market rumbles on, we all know in retrospect what we could have, should have, would have done with our money, if only we’d had the courage to act--especially when the conventional wisdom was leaning heavily one way and we suspected that wisdom to be misguided.

Playing that game well--confidently going against the herd and profiting handsomely for it--is the special skill of the “contrarian” investor. There are relatively few of them, and for a simple reason.

“It’s much warmer inside the herd” than outside, notes Jean-Marie Eveillard, manager of the SoGen International mutual fund and a veteran Wall Street contrarian. To invest away from the crowd is by definition a lonely, stressful occupation.

But it can be extraordinarily lucrative. Consider:

* In autumn 1990, many bank stocks were priced as if the entire industry was headed for failure. The crowd was wrong. One share of Citicorp then: $11. Now: $75.

* In June 1994, the crowd hated major drug stocks, which had at that point suffered through a 30-month bear market wrought by tremendous upheaval in the health-care industry. The crowd was wrong: One share of Merck & Co. then: $29. Now: $70.

* In January 1995, many investors were still shellshocked after the relentless interest-rate increases of 1994. Almost no one believed that a 7.8% yield on a 30-year Treasury bond was worth the risk.

The crowd was wrong: A 30-year bond now yields 6.1%, and plenty of investors would kill just to get 7% again, let alone something closer to 8%.

Today, the crowd loves stocks--just about any stock. Instinct tells some investors that it’s time to sell. The crowd must be wrong, right?

Maybe. Except that if you think back to 1989, the crowd that is the investing public has been growing every year since. And in general, the right thing to have done for the last six years is to have stayed fully invested in a diversified portfolio of stocks.

The crowd can be right. Or it can be dead wrong. Knowing which way to bet in a given situation is, of course, what distinguishes the truly savvy contrarians.

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How do you learn to discern a smart contrarian bet? Start by understanding that contrarian investing isn’t simply buying what appears to be out of favor.

Stocks often get crushed for very good reasons. At the extreme, the market may be signaling that a particular company or industry is headed for oblivion.

“There is ‘dumb contrarianism,’ ” says John Rekenthaler, publisher of Morningstar Mutual Funds in Chicago. “You could be talking about an industry going to zero.” Buggy whip makers, he notes, probably looked to some investors like good contrarian bets as the auto age was dawning.

Even with a distressed stock that is likely to be a survivor in the long run, the risk that all contrarians face is being far too early. The Mexican stock market crash of 1994-95 is a case in point. Shares of resort operator Grupo Sidek, which traded as high as $22.75 on the New York Stock Exchange in 1994, may have looked like a bargain at $10 early in 1995. Now the stock sells at $2.63.

Every contrarian has horror stories to tell about being too early. Buying what’s out of favor “can be like catching a falling knife,” says SoGen’s Eveillard.

Most recently, he was buying shares of troubled Apple Computer as the price tumbled from $50 to $40. “My idea was that their problems are temporary, they have a pile of cash, and they have great [customer] loyalty,” he says.

Yet the stock has slumped further, to $27.75 currently. “So far I’m wrong,” Eveillard says.

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Nonetheless, Apple does appear to have some of the key attributes contrarians look for in beaten-up stocks--in particular, a significant intrinsic value to the basic business.

The contrarians’ hunt for unappreciated worth is the major reason why contrarianism is often equated with value investing, the Wall Street school that favors “cheap” stocks, usually defined as shares that sell for low prices relative to earnings per share.

But although contrarians and value investors often find themselves on the same side, they don’t always like the same stocks.

Many value investors, for example, were still buying electric utility shares in the summer of 1993 because the stocks’ price-to-earnings ratios were low and their dividend yields high, at least compared with the rest of the market.

By the time the stocks peaked that September, they were anything but out-of-favor issues. In fact, the smart contrarian bet at that point would have been to “short” utilities: They soon crashed.

Veteran contrarians say the most important judgments they must make in researching a downtrodden security are, first, that the price is well below the true value of the business, and, second, that the problems dogging the business are temporary, not permanent or fatal.

David Dreman, head of Dreman Value Advisors in New York and a well-known contrarian, bought drug stocks near their lows two years ago because, he says, he felt that the market was grossly overreacting to concerns about federal health-care reform.

Investors had pounded stocks such as Merck down as much as 50% from their 1992 highs, yet “we thought that these companies would continue to exist no matter who was in power” in Washington, Dreman says.

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Eveillard felt much the same about bonds of certain Third World countries a year ago, when yields were sky-high. “The only risk at that point was that the countries would default on their debts, but in my judgment that risk was very low,” he says. He was right, and the bonds’ values have since rebounded sharply.

Martin Whitman, manager of the Third Avenue Value stock fund in New York, describes his classic contrarian security as being “safe and cheap”: “safe” meaning that the company is financially strong, and “cheap” meaning that the market price of the security fails to fully reflect the private market value of the company.

Naturally, such judgments look easy in hindsight when a contrarian guesses correctly. “But at the time you’re making the decision, it’s not easy at all,” Dreman says.

Which is why it’s so difficult, emotionally, to invest away from the crowd. “Being a contrarian doesn’t just take insight, but also nerve,” Eveillard says.

It also takes patience, a quality usually in short supply on Wall Street. Contrarians must be willing to wait for the crowd to see the light and turn unloved securities into must-own securities again.

That can take a long time. But if it’s any inspiration, the most famous contrarian of all is billionaire Warren Buffett. Once he zeros in on a genuine-value stock, his favorite holding period is “forever.”

What’s Contrarian Now? You want to invest against the wind today? Here’s what some pros recommend:

* U.S. small-company stocks: They’ve lagged blue chips for two years. Bill Nasgovitz, manager of the Heartland Small Cap Contrarian fund in Milwaukee, says the longer Wall Street ignores small stocks, the greater the values become.

Small retail stocks in particular are a “disaster group” after the poor Christmas season, Nasgovitz says. Yet many debt-free small retailers will easily survive the industry shakeout, he says.

* Foreign small-company stocks: In Europe, small stocks have been out of favor for so long that “the locals don’t even want to hear about them,” Eveillard says. That’s often a good cue, he adds. Eveillard also continues to like gold, as does Paul Stephens, manager of the Robertson Stephens Contrarian fund in San Francisco.

* Clothing makers: Dreman says prices of stocks like Fruit of the Loom and VF Corp. reflect the industry’s current slump but not consumers’ long-term need for apparel.

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Quite Contrarian

These stock mutual funds have earned a reputation for “contrarian” investing--that is, investing away from the crowd

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Total return: Fund 1995 1996 Five-year return* Kemper-Dreman High-Return +46.9% +5.1% +180.8% Third Avenue Value +31.7 +3.2 +161.7 Crabbe Huson Special +10.8 -1.6 +160.0 Neuberger & Berger Guardian +32.1 +3.8 +143.2 Mutual Shares +29.1 +5.3 +139.7 Kemper-Dreman Contrarian +44.6 +3.6 +122.1 SoGen International +15.2 +4.8 +90.6 Heartland Small Cap Contrarian NA +5.3 NA Robertson Stephens Contrarian +30.9 +15.2 NA General Stock Fund Average +31.1 +15.2 NA International Stock Fund Average +9.4 +2.9 +63.5

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NA: Not available (fund didn’t exist for entire period)

*Through Dec. 31, 1995

Source: Lipper Analytical Services