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Thinking Differently: The Most Important Contrarian Behavior

October 03, 2013 | About:
“I skate to where the puck is going to be, not where it has been.” - Wayne Gretzky

One of the most important skills that you can develop as an investor is the ability to think differently. This is a broad topic with many interpretations. I often talk about thinking differently here at BHI. When it comes to general philosophy or “investment theory” (as opposed to thinking about individual stock investments), I spend more time thinking about this topic than any other. In short, I’m referring to the ability to think in a contrarian manner.

Contrarian Thinking over Contrarian Acting

But, I’m not talking about being a contrarian in the usual sense, i.e. buying stocks at new lows, buying what others hate, etc. This type of contrarian behavior typically revolves around current price and/or sentiment. When applied as part of more important inputs (namely valuation, quality, etc.), there is nothing wrong with this contrarian behavior. I often look at stocks that contrarians are interested in.

But simply buying stocks that have dropped a lot or buying stocks that others don’t like are not prudent ways to invest.

As Ben Graham says: [/b]“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”[b]

So contrarian action is often a common denominator in successful long term investment results. But what I’m talking about is a bigger, broader definition of contrarianism. I’m referring to the ability to think differently (not just act differently).

Do You Need to Know Something the Market Doesn’t?

Geoff Gannon wrote a fantastic post recently called “Do You Need to Know Something the Market Doesn’t?“. I thought he really hit the nail on the head. Geoff is a unique and independent thinker, and I recommend reading that post in its entirety. In it, he basically states that he doesn’t necessarily feel he has much of an informational advantage over the market (i.e. the majority of other market participants).

For example, he uses the same data the analysts use when doing their valuation work. All the historical data is already known. Everyone knows what the prior year’s earnings, sales, margins, etc. have been. Next year’s numbers are unknown, but many, many smart people make very good estimates on where those numbers will end up.

Geoff goes on to say that in addition to not really feeling he has an informational advantage regarding current or next year’s numbers, he also doesn’t feel he adds much value when it comes to explaining why a stock is cheap, when to sell, how to position size and other very important strategic and tactical facets of investing.

It’s Not the Info That Matters, It’s the Way You Think About It

So if there is no informational advantage over the market, and there isn’t much value to be added in portfolio management or other strategic aspects of investing, how does one go about trying to achieve superior returns?

The answer according to Geoff (and I agree with him) is his ability to think in a completely different way than most market participants think. He talks about looking out to try and determine what will happen in “year four.″ Most market participants focus on the next year. Some might focus on two to three years out. Hardly anyone looks out to year four.

Joel Greenblatt often talked about this as one of the main reasons (in addition to superior portfolio management tactics) he was able to achieve 40% returns for 20 years.

So simply extending the time frame is one way to gain a major advantage. Instead of focusing on how the current news will affect the company in the next year or two, try to visualize what will happen in year four. Buffett even took it beyond that by saying that before he bought any stock, he closed his eyes and tried to visualize what the company would look like in 10 years.

No one does that. Or I should say, no average investor (professionals included) does that. A very, very select few do. And often times this is a common denominator among the small group who have crushed the market averages over the long term.

Look where no one else is looking. ”Go where the puck is going to be,” not where it is now (which is where everyone is looking).

What Metrics Matter? Think Differently…

So changing the time frame is one way to build an edge. Another is to begin to place importance on things that no one else cares about. For instance, Coke (KO) is a case study that you can learn many things from. Buffett and Munger both shocked the value investing world when they paid 15 times earnings for an established, large cap, well-known brand name with virtually no tangible asset protection. This Coke investment in the late '80s exemplified the art of thinking differently.

I’m not suggesting that you should arbitrarily begin paying high multiples for good businesses. I’m just suggesting that you can learn something by studying the thought process that Buffett and Munger used to make their Coke investment.

A while back I wrote a post on Pabrai’s thoughts on why Buffett bought Coke. He and Munger didn’t think about current earnings, or next year’s earnings. They thought about things like:

  • Brand replacement value (estimated at five times the then market value).
  • Volume of syrup shipped in the year 2000, 2025, 2050 (remember, they did this analysis in the late '80s).
  • Daily per capita consumption of bottled beverages.
  • Price per eight ounce serving.
Not exactly the typical metrics. No multiples, no margins, no forward year estimates.

As Mohnish Pabrai said in his book:
The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the next half century when trying to figure out any given company. No Wall Street analyst’s mental model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon.
One more thing about Coke… Please read Charlie Munger’s thesis on How to Turn $2 million into $2 trillion (who one outstanding fund manager called the best investment writeup he’s ever seen).

Again, you’ll find lots of unique, inverted thinking.

Munger and Buffett thought differently. This is how they were able to make 10 times their money on Coke. This is how Buffett made 50% per year, and guaranteed he could do it again if he could only go back to managing a smaller sum.

It All Comes Down to Thinking Like a Business Owner

Last thing: I love simplicity (as I’ve mentioned many times). The simple conclusion here — the moral of the story so to speak — is that Buffett and Munger thought about stocks the same way businessmen think about the businesses they buy/own. I know, this is ubiquitous language: “Think about stocks like fractions of businesses.” Everyone says it. But, hardly anyone actually invests this way.

I guarantee the vast majority of investors who were fortunate enough to buy Coke in the '80s were not thinking the way Buffett and Munger were. Buffett was thinking years, even decades ahead. Like a business owner.

It paid off, and it’s a way to gain an advantage over the vast majority of market participants who think about things like relative value, what another investor will pay in a year or two, or what next year’s earnings are.

To sum it up. two things that can establish a true contrarian advantage are:

  • Extend the time frame (via Geoff Gannon’s outstanding post)
  • Place importance on things that others aren’t thinking about
These are just two things. There are countless of other ways to think about investments.

The main thing is to Think Differently. Think like a business owner would. Simple, but uncommon.

About the author:

John Huber
I am the Portfolio Manager at Saber Capital Management, LLC. Saber manages an investment partnership as well as separately managed accounts for clients interested in a focused value investing strategy. My investment style has been most influenced by Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. I am also the author of www.BaseHitInvesting.com, a value investing blog.

Visit John Huber's Website


Rating: 3.7/5 (20 votes)

Comments

valueradar
Valueradar premium member - 11 months ago
Thank you for the nice article!
20punches
20punches - 11 months ago
Thanks for an article worth reading, John. I'm sure you know this but Howard Marks has a whole chapter on second level thinking, which is also very thought provoking.
vgm
Vgm - 11 months ago
Jianing - agree. I mentioned the relevance of "second level thinking" to the present topic in a comment to Goeff's excellent article a couple of days ago.

John - another nice piece. I'd challenge your title, however. Channeling Howard Marks in 'The Most Important Thing', thinking differently is not sufficient. Marks tells us what's actually required is: to think differently AND at a higher level than the consensus. The challenge is to find non-consensus views on value where you believe you have a high probability of being correct. The task is non-trivial and it's where the 'art' of investing comes into play. Buffett/Munger and Coke is a great example. But stocks which are hated and have been beaten down can be starting points too (BAC in 2011, for example)

The second edition of the book entitled 'The Most Important Thing Illuminated' is especially recommendable, as it has in situ commentary from Seth Klarman and Joel Greenblatt among others.

Thanks for the stimulation.

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